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CHAPTER

D i s t r i b u t i o n s t oS h a r e ho l de r s : D i v i de nd sa nd S h a r e R e p u r c h a s e s

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stock price.1 Here is the text of the letter sent to its

stockholders in which FPL announced these changes:

Dear Shareholder,

Over the past several years, we have been working

hard to enhance shareholder value by aligning our

strategy with a rapidly changing business

environment. . . . The Energy Policy Act of 1992

has brought permanent changes to the electric

industry. Although we have taken effective and

sometimes painful steps to prepare for these

changes, one critical problem remains. Our dividend

payout ratio of 90 percent — the percentage of our

earnings paid to shareholders as dividends — is far

too high for a growth company. It is well above the

industry average, and it has limited the growth in

the price of our stock.

To meet the challenges of this competitive

marketplace and to ensure the financial strength and

flexibility necessary for success, the Board of

Directors has announced a change in our financial

strategy that includes the following milestones:

� A new dividend policy that provides for paying

out 60 to 65 percent of prior years’ earnings.

This means a reduction in the quarterly

dividend from 62 to 42 cents per share

beginning with the next payment.

rofitable companies regularly face three important

questions. (1) How much of its free cash flow

should it pass on to shareholders? (2) Should it

provide this cash to stockholders by raising the dividend

or by repurchasing stock? (3) Should it maintain a

stable, consistent payment policy, or should it let the

payments vary as conditions change?

In this chapter we will discuss many of the issues

that affect a firm’s cash distribution policy. As we will

see, most firms establish a policy that considers their

forecasted cash flows and forecasted capital

expenditures, and then try to stick to it. The policy

can be changed, but this can cause problems because

such changes inconvenience shareholders, send

unintended signals, and convey the impression of

dividend instability, all of which have negative

implications for stock prices. Still, economic

circumstances do change, and occasionally such

changes require firms to change their dividend

policies.

One of the most striking examples of a dividend

policy change occurred in May 1994, when FPL Group, a

utility holding company whose primary subsidiary is

Florida Power & Light, announced a cut in its quarterly

dividend from $0.62 per share to $0.42. At the same

time, FPL stated that it would buy back 10 million of its

common shares over the next three years to bolster its

F P L S T U N S T H EM A R K E T BY C H A N G I N G I T S D I V I D E N D P O L IC Y

FPL GROUP

$

P

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1 For a complete discussion of the FPL decision, see Dennis Soter, Eugene Brigham, and Paul Evanson, “The Dividend Cut Heard‘Round the World: The Case of FPL,” Journal of Applied Corporate Finance, Spring 1996, 4–15. Also, note that stock repurchasesare discussed in a later section of this chapter.

C H A P T E R 1 4 � D IS T R I B U T IO N S TO S H A R E HO L D E R S : D I V I D E N D S A N D S H A R E R E P U R C H A S E S642

We appreciate your understanding and support,

and we will continue to provide updates on our

progress in forthcoming shareholder reports.

Several analysts called the FPL decision a watershed

event for the electric utility industry. FPL saw that its

circumstances were changing — its core electric

business was moving from a regulated monopoly

environment to one of increasing competition, and the

new environment required a stronger balance sheet and

more financial flexibility than was consistent with a 90

percent payout policy.

What did the market think about FPL’s dividend

policy change? The company’s stock price fell by 14

percent the day the announcement was made. In the

past, hundreds of dividend cuts followed by sharply

lower earnings had conditioned investors to expect the

worst when a company reduces its dividend — this is

the signaling effect, which is discussed later in the

chapter. However, over the next few months, as they

understood FPL’s actions better, analysts began to praise

the decision and to recommend the stock. As a result,

FPL’s stock outperformed the average utility and soon

exceeded the pre-announcement price. �

� The authorization to repurchase 10 million

shares of common stock over the next three

years, including at least 4 million shares in the

next year.

� An earlier dividend evaluation beginning in

February 1995 to more closely link dividend

rates to annual earnings.

We believe this financial strategy will enhance

long-term share value and will facilitate both

earnings per share and dividend growth to about 5

percent per year over the next several years.

Adding to shareholder wealth in this manner

should be increasingly significant given recent

changes in the tax law, which have made

capital gains more attractive than dividend

income.

. . . We take this action from a position of

strength. We are not being forced into a defensive

position by expectations of poor financial

performance. Rather, it is a strategic decision to

align our dividend policy and your total return as a

shareholder with the growth characteristics of our

company.

Successful companies earn income. That income can then be reinvested in operat-

ing assets, used to acquire securities, used to retire debt, or distributed to stock-

holders. If the decision is made to distribute income to stockholders, three key is-

sues arise: (1) How much should be distributed? (2) Should the distribution be as

cash dividends, or should the cash be passed on to shareholders by buying back

some of the stock they hold? (3) How stable should the distribution be; that is,

should the funds paid out from year to year be stable and dependable, which

stockholders would probably prefer, or be allowed to vary with the firms’ cash

flows and investment requirements, which would probably be better from the firm’s

An excellent source ofrecent dividend newsreleases for majorcorporations is available at the web site of

Corporate Financials Online athttp://www.cfonews.com/scs. Byclicking the down arrow of the “NewsCategory” box to the left of the screen,students may select “Dividends” toreceive a list of companies withdividend news. Click on any company,and you will see its latest dividendnews.

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standpoint? These three issues are the primary focus of this chapter, but we also

consider two related issues, stock dividends and stock splits. �

D I V I D E N D S V E R S U S C A P I TA L GA I N S : W H AT D O I N V E S TO R S P R E F E R ?

When deciding how much cash to distribute to stockholders, financial man-agers must keep in mind that the firm’s objective is to maximize shareholdervalue. Consequently, the target payout ratio — defined as the percentage ofnet income to be paid out as cash dividends — should be based in large part oninvestors’ preferences for dividends versus capital gains: do investors prefer (1)to have the firm distribute income as cash dividends or (2) to have it either re-purchase stock or else plow the earnings back into the business, both of whichshould result in capital gains? This preference can be considered in terms of theconstant growth stock valuation model:

P̂0 �

If the company increases the payout ratio, this raises D1. This increase in thenumerator, taken alone, would cause the stock price to rise. However, if D1 israised, then less money will be available for reinvestment, that will cause the ex-pected growth rate to decline, and that will tend to lower the stock’s price.Thus, any change in payout policy will have two opposing effects. Therefore,the firm’s optimal dividend policy must strike a balance between current div-idends and future growth so as to maximize the stock price.

In this section we examine three theories of investor preference: (1) the div-idend irrelevance theory, (2) the “bird-in-the-hand” theory, and (3) the tax pref-erence theory.

DIVIDEND IRRELEVANCE THEORY

It has been argued that dividend policy has no effect on either the price of afirm’s stock or its cost of capital. If dividend policy has no significant effects,then it would be irrelevant. The principal proponents of the dividend irrele-vance theory are Merton Miller and Franco Modigliani (MM).2 They arguedthat the firm’s value is determined only by its basic earning power and its busi-ness risk. In other words, MM argued that the value of the firm depends onlyon the income produced by its assets, not on how this income is split betweendividends and retained earnings.

To understand MM’s argument that dividend policy is irrelevant, recognizethat any shareholder can in theory construct his or her own dividend policy.For example, if a firm does not pay dividends, a shareholder who wants a 5 per-cent dividend can “create” it by selling 5 percent of his or her stock. Con-versely, if a company pays a higher dividend than an investor desires, the

D1

ks � g.


Target Payout RatioThe percentage of net incomepaid out as cash dividends.

Optimal Dividend PolicyThe dividend policy that strikes abalance between current dividendsand future growth and maximizesthe firm’s stock price.

Dividend Irrelevance TheoryThe theory that a firm’s dividendpolicy has no effect on either itsvalue or its cost of capital.

2 Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation ofShares,” Journal of Business, October 1961, 411–433.


investor can use the unwanted dividends to buy additional shares of the com-pany’s stock. If investors could buy and sell shares and thus create their owndividend policy without incurring costs, then the firm’s dividend policy wouldtruly be irrelevant. Note, though, that investors who want additional dividendsmust incur brokerage costs to sell shares, and investors who do not want divi-dends must first pay taxes on the unwanted dividends and then incur brokeragecosts to purchase shares with the after-tax dividends. Since taxes and brokeragecosts certainly exist, dividend policy may well be relevant.

In developing their dividend theory, MM made a number of assumptions,especially the absence of taxes and brokerage costs. Obviously, taxes and bro-kerage costs do exist, so the MM irrelevance theory may not be true. However,MM argued (correctly) that all economic theories are based on simplifying as-sumptions, and that the validity of a theory must be judged by empirical tests,not by the realism of its assumptions. We will discuss empirical tests of MM’sdividend irrelevance theory shortly.

BIRD-IN-THE-HAND THEORY

The principal conclusion of MM’s dividend irrelevance theory is that dividendpolicy does not affect the required rate of return on equity, ks. This conclusionhas been hotly debated in academic circles. In particular, Myron Gordon andJohn Lintner argued that ks decreases as the dividend payout is increased be-cause investors are less certain of receiving the capital gains that are supposedto result from retaining earnings than they are of receiving dividend payments.3

Gordon and Lintner said, in effect, that investors value a dollar of expected div-idends more highly than a dollar of expected capital gains because the dividendyield component, D1/P0, is less risky than the g component in the total ex-pected return equation, ks � D1/P0 � g.

MM disagreed. They argued that ks is independent of dividend policy, whichimplies that investors are indifferent between D1/P0 and g and, hence, be-tween dividends and capital gains. MM called the Gordon-Lintner argumentthe bird-in-the-hand fallacy because, in MM’s view, most investors plan toreinvest their dividends in the stock of the same or similar firms, and, in anyevent, the riskiness of the firm’s cash flows to investors in the long run is de-termined by the riskiness of operating cash flows, not by dividend payoutpolicy.

TAX PREFERENCE THEORY

There are three tax-related reasons for thinking that investors might prefer alow dividend payout to a high payout: (1) Recall from Chapter 2 that long-termcapital gains are taxed at a rate of 20 percent, whereas dividend income is taxedat effective rates that go up to 39.6 percent. Therefore, wealthy investors (whoown most of the stock and receive most of the dividends) might prefer to have

3 Myron J. Gordon, “Optimal Investment and Financing Policy,” Journal of Finance, May 1963,264–272; and John Lintner, “Dividends, Earnings, Leverage, Stock Prices, and the Supply of Cap-ital to Corporations,” Review of Economics and Statistics, August 1962, 243–269.

Bird-in-the-Hand TheoryMM’s name for the theory that afirm’s value will be maximized bysetting a high dividend payoutratio.

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companies retain and plow earnings back into the business. Earnings growthwould presumably lead to stock price increases, and thus lower-taxed capitalgains would be substituted for higher-taxed dividends. (2) Taxes are not paid onthe gain until a stock is sold. Due to time value effects, a dollar of taxes paid inthe future has a lower effective cost than a dollar paid today. (3) If a stock isheld by someone until he or she dies, no capital gains tax is due at all — thebeneficiaries who receive the stock can use the stock’s value on the death day astheir cost basis and thus completely escape the capital gains tax.

Because of these tax advantages, investors may prefer to have companies re-tain most of their earnings. If so, investors would be willing to pay more forlow-payout companies than for otherwise similar high-payout companies.

ILLUSTRAT ION OF THE THREE DIVIDENDPOLICY THEORIES

Figure 14-1 illustrates the three alternative dividend policy theories: (1) Millerand Modigliani’s dividend irrelevance theory, (2) Gordon and Lintner’s bird-in-the-hand theory, and (3) the tax preference theory. To understand the threetheories, consider the case of Hardin Electronics, which has from its inceptionplowed all earnings back into the business and thus has never paid a dividend.Hardin’s management is now reconsidering its dividend policy, and it wants toadopt the policy that will maximize its stock price.

Consider first the data presented below the graph. Each row shows an alter-native payout policy: (1) Retain all earnings and pay out nothing, which is thepresent policy, (2) pay out 50 percent of earnings, and (3) pay out 100 percentof earnings. In the example, we assume that the company will have a 15 percentROE regardless of which payout policy it follows, so with a book value pershare of $30, EPS will be 0.15($30) � $4.50 under all payout policies.4 Givenan EPS of $4.50, dividends per share are shown in Column 3 under eachpayout policy.

Under the assumption of a constant ROE, the growth rate shown in Column4 will be g � (% Retained)(ROE), and it will vary from 15 percent at a zeropayout to zero at a 100 percent payout. For example, if Hardin pays out 50 per-cent of its earnings, then its dividend growth rate will be g � 0.5(15%) � 7.5%.

Columns 5, 6, and 7 show how the situation would look if MM’s irrelevancetheory were correct. Under this theory, neither the stock price nor the cost ofequity would be affected by the payout policy — the stock price would remainconstant at $30, and ks would be stable at 15 percent. Note that ks is found asthe sum of the growth rate in Column 4 plus the dividend yield in Column 6.

Columns 8, 9, and 10 show the situation if the bird-in-the-hand theory weretrue. Under this theory, investors prefer dividends, and the more of its earningsthe company pays out, the higher its stock price and the lower its cost of equity.


4 When the three theories were developed, it was assumed that a company’s investment opportuni-ties would be held constant and that if the company increased its dividends, its capital budget couldbe funded by selling common stock. Conversely, if a high-payout company lowered its payout tothe point where earnings exceeded good investment opportunities, it was assumed that the com-pany would repurchase shares. Transactions costs were assumed to be immaterial. We maintainthose assumptions in our example.


POSSIBLE SITUATIONS (ONLY ONE CAN BE TRUE)ALTERNATIVE

PAYOUT POLICIES MM: IRRELEVANCE BIRD-IN-THE-HAND TAX PREFERENCE

PERCENT PERCENTPAYOUT RETAINED DPS g P0 D/P0 kS P0 D/P0 kS P0 D/P0 kS

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)

0% 100% $0.00 15.0% $30 0.0% 15.0% $30 0.00% 15.00% $30 0.0% 15.0%50 50 2.25 7.5 30 7.5 15.0 35 6.43 13.93 25 9.0 16.5

100 0 4.50 0.0 30 15.0 15.0 40 11.25 11.25 20 22.5 22.5

NOTES:

1. Book value � Initial market value � $30 per share.

2. ROE � 15%.

3. EPS � $30(0.15) � $4.50.

4. g � (% retained)(ROE) � (% retained)(15%). Example: At payout � 50%, g � 0.5(15%) � 7.5%.

5. ks � Dividend yield � Growth rate.

F I G U R E 1 4 - 1Dividend Irrelevance, Bird-in-the-Hand, and Tax Preference Dividend Theories

Stock Price, P0($)

0 50% 100%

30

20

10

Payout

40 Bird-in-the-Hand

MM: Irrelevance

Tax Preference

Cost of Equity, ks(%)

0 50% 100%

15.00

11.25

Payout

Bird-in-the-Hand

MM: Irrelevance

Tax Preference22.50

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In our example, the bird-in-the-hand theory indicates that adopting a 100 per-cent payout policy would cause the stock price to rise from $30 to $40, and thecost of equity would decline from 15 percent to 11.25 percent.

Finally, Columns 11, 12, and 13 show the situation if the tax preference the-ory were correct. Under this theory, investors prefer companies that retainearnings and thus provide returns in the form of lower-taxed capital gainsrather than higher-taxed dividends. If the tax preference theory were correct,then an increase in the dividend payout ratio from its current zero level wouldcause the stock price to decline and the cost of equity to rise.

The data in the table are plotted to produce the two graphs shown in Figure14-1. The upper graph shows how the stock price would react to dividend pol-icy under each of the theories, and the lower graph shows how the cost of eq-uity would be affected.

USING EMPIR ICAL EVIDENCE TO DECIDEWHICH THEORY IS BEST

These three theories offer contradictory advice to corporate managers, so which,if any, should we believe? The most logical way to proceed is to test the theoriesempirically. Many such tests have been conducted, but their results have beenunclear. There are two reasons for this: (1) For a valid statistical test, things otherthan dividend policy must be held constant; that is, the sample companies mustdiffer only in their dividend policies, and (2) we must be able to measure with ahigh degree of accuracy each firm’s cost of equity. Neither of these two condi-tions holds: We cannot find a set of publicly owned firms that differ only in theirdividend policies, nor can we obtain precise estimates of the cost of equity.

Therefore, no one can establish a clear relationship between dividend policyand the cost of equity. Investors in the aggregate cannot be seen to uniformlyprefer either higher or lower dividends. Nevertheless, individual investors dohave strong preferences. Some prefer high dividends, while others prefer allcapital gains. These differences among individuals help explain why it is diffi-cult to reach any definitive conclusions regarding the optimal dividend payout.Even so, both evidence and logic suggest that investors prefer firms that followa stable, predictable dividend policy (regardless of the payout level). We will con-sider the issue of dividend stability later in the chapter.


SELF-TEST QUESTIONS

Explain the differences among the dividend irrelevance theory, the bird-in-the-hand theory, and the tax preference theory. Use a graph such as Figure14-1 to illustrate your answer.

What did Modigliani and Miller assume about taxes and brokerage costswhen they developed their dividend irrelevance theory?

How did the bird-in-the-hand theory get its name?

In what sense does MM’s theory represent a middle-ground position betweenthe other two theories?

What have been the results of empirical tests of the dividend theories?


OT H E R D I V I D E N D P O L I C Y I S S U E S

Before we discuss how dividend policy is set in practice, we must examinetwo other theoretical issues that could affect our views toward dividend policy:(1) the information content, or signaling, hypothesis and (2) the clientele effect.

INFORMATION CONTENT, OR S IGNALING, HYPOTHES IS

When MM set forth their dividend irrelevance theory, they assumed thateveryone — investors and managers alike — has identical information regarding

Dividend yields vary considerably in different stock marketsthroughout the world. In 1999 in the United States, divi-

dend yields averaged 1.6 percent for the large blue chip stocksin the Dow Jones Industrials, 1.2 percent for a broader sampleof stocks in the S&P 500, and 0.3 percent for stocks in the

high-tech-dominated Nasdaq. Outside the United States, aver-age dividend yields ranged from 5.7 percent in New Zealand to0.7 percent in Taiwan. The accompanying table summarizes thedividend picture in 1999.

DIVIDEND YIELDS AROUND THE WORLD

WORLD STOCK MARKET (INDEX) DIVIDEND YIELD

New Zealand 5.7%Australia 3.1Britain FTSE 100 2.4Hong Kong 2.4France 2.1Germany 2.1Belgium 2.0Singapore 1.7United States (Dow Jones Industrials) 1.6Canada (TSE 300) 1.5United States (S&P 500) 1.2Mexico 1.1Japan Nikkei 0.7Taiwan 0.7United States (Nasdaq) 0.3

SOURCE: Alexandra Eadie, “On the Grid Looking for Dividend Yield Around theWorld,” The Globe and Mail, June 23, 1999, B16. Eadie’s source was Bloomberg Fi-nancial Services.

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the firm’s future earnings and dividends. In reality, however, different investorshave different views on both the level of future dividend payments and the un-certainty inherent in those payments, and managers have better informationabout future prospects than public stockholders.

It has been observed that an increase in the dividend is often accompaniedby an increase in the price of a stock, while a dividend cut generally leads to astock price decline. This could indicate that investors, in the aggregate, preferdividends to capital gains. However, MM argued differently. They noted thewell-established fact that corporations are reluctant to cut dividends, hence donot raise dividends unless they anticipate higher earnings in the future. Thus,MM argued that a higher-than-expected dividend increase is a “signal” to in-vestors that the firm’s management forecasts good future earnings.5 Conversely,a dividend reduction, or a smaller-than-expected increase, is a signal that man-agement is forecasting poor earnings in the future. Thus, MM argued that in-vestors’ reactions to changes in dividend policy do not necessarily show that in-vestors prefer dividends to retained earnings. Rather, they argue that pricechanges following dividend actions simply indicate that there is an importantinformation, or signaling, content in dividend announcements.

Like most other aspects of dividend policy, empirical studies of signalinghave had mixed results. There is clearly some information content in dividendannouncements. However, it is difficult to tell whether the stock price changesthat follow increases or decreases in dividends reflect only signaling effects orboth signaling and dividend preference. Still, signaling effects should definitelybe considered when a firm is contemplating a change in dividend policy.

CLIENTELE EFFECT

As we indicated earlier, different groups, or clienteles, of stockholders prefer dif-ferent dividend payout policies. For example, retired individuals and universityendowment funds generally prefer cash income, so they may want the firm topay out a high percentage of its earnings. Such investors (and pension funds)are often in low or even zero tax brackets, so taxes are of no concern. On theother hand, stockholders in their peak earning years might prefer reinvestment,because they have less need for current investment income and would simplyreinvest dividends received, after first paying income taxes on those dividends.

If a firm retains and reinvests income rather than paying dividends, thosestockholders who need current income would be disadvantaged. The value oftheir stock might increase, but they would be forced to go to the trouble andexpense of selling off some of their shares to obtain cash. Also, some institu-tional investors (or trustees for individuals) would be legally precluded from

OT H E R D I V I D E N D P O L I C Y I S S U E S

Information Content(Signaling) HypothesisThe theory that investors regarddividend changes as signals ofmanagement’s earnings forecasts.

5 Stephen Ross has suggested that managers can use capital structure as well as dividends to givesignals concerning firms’ future prospects. For example, a firm with good earnings prospects cancarry more debt than a similar firm with poor earnings prospects. This theory, called incentive sig-naling, rests on the premise that signals with cash-based variables (either debt interest or dividends)cannot be mimicked by unsuccessful firms because such firms do not have the future cash-generating power to maintain the announced interest or dividend payment. Thus, investors aremore likely to believe a glowing verbal report when it is accompanied by a dividend increase or adebt-financed expansion program. See Stephen A. Ross, “The Determination of Financial Struc-ture: The Incentive-Signaling Approach,” The Bell Journal of Economics, Spring 1977, 23–40.


selling stock and then “spending capital.” On the other hand, stockholders whoare saving rather than spending dividends might favor the low dividend policy,for the less the firm pays out in dividends, the less these stockholders will haveto pay in current taxes, and the less trouble and expense they will have to gothrough to reinvest their after-tax dividends. Therefore, investors who wantcurrent investment income should own shares in high dividend payout firms,while investors with no need for current investment income should own sharesin low dividend payout firms. For example, investors seeking high cash incomemight invest in electric utilities, which averaged a 73 percent payout from 1996through 2000, while those favoring growth could invest in the semiconductorindustry, which paid out only 7 percent during the same time period.

To the extent that stockholders can switch firms, a firm can change from onedividend payout policy to another and then let stockholders who do not like thenew policy sell to other investors who do. However, frequent switching wouldbe inefficient because of (1) brokerage costs, (2) the likelihood that stockholderswho are selling will have to pay capital gains taxes, and (3) a possible shortage ofinvestors who like the firm’s newly adopted dividend policy. Thus, managementshould be hesitant to change its dividend policy, because a change might causecurrent shareholders to sell their stock, forcing the stock price down. Such aprice decline might be temporary, but it might also be permanent — if few newinvestors are attracted by the new dividend policy, then the stock price wouldremain depressed. Of course, the new policy might attract an even larger clien-tele than the firm had before, in which case the stock price would rise.

Evidence from several studies suggests that there is in fact a clientele ef-fect.6 MM and others have argued that one clientele is as good as another, sothe existence of a clientele effect does not necessarily imply that one dividendpolicy is better than any other. MM may be wrong, though, and neither theynor anyone else can prove that the aggregate makeup of investors permits firmsto disregard clientele effects. This issue, like most others in the dividend arena,is still up in the air.

6 For example, see R. Richardson Pettit, “Taxes, Transactions Costs and the Clientele Effect ofDividends,” The Journal of Financial Economics, December 1977, 419–436.

Clientele EffectThe tendency of a firm to attract aset of investors who like itsdividend policy.

SELF-TEST QUESTION

Define (1) information content and (2) the clientele effect, and explain howthey affect dividend policy.

D I V I D E N D S TA B I L I T Y

As we noted at the beginning of the chapter, the stability of dividends is also im-portant. Profits and cash flows vary over time, as do investment opportunities.Taken alone, this suggests that corporations should vary their dividends overtime, increasing them when cash flows are large and the need for funds is low andlowering them when cash is in short supply relative to investment opportunities.However, many stockholders rely on dividends to meet expenses, and they wouldbe seriously inconvenienced if the dividend stream were unstable. Further,

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reducing dividends to make funds available for capital investment could sendincorrect signals to investors, who might push down the stock price because theyinterpreted the dividend cut to mean that the company’s future earnings prospectshave been diminished. Thus, maximizing its stock price requires a firm to balanceits internal needs for funds against the needs and desires of its stockholders.

How should this balance be struck; that is, how stable and dependableshould a firm attempt to make its dividends? It is impossible to give a definitiveanswer to this question, but the following points are relevant:

1. Virtually every publicly owned company makes a five- to ten-year finan-cial forecast of earnings and dividends. Such forecasts are never madepublic — they are used for internal planning purposes only. However, se-curity analysts construct similar forecasts and do make them available toinvestors; see Value Line for an example. Further, virtually every internalfive- to ten-year corporate forecast we have seen for a “normal” companyprojects a trend of higher earnings and dividends. Both managers and in-vestors know that economic conditions may cause actual results to differfrom forecasted results, but “normal” companies expect to grow.

2. Years ago, when inflation was not persistent, the term “stable dividendpolicy” meant a policy of paying the same dollar dividend year after year.AT&T was a prime example of a company with a stable dividend policy —it paid $9 per year ($2.25 per quarter) for 25 straight years. Today,though, most companies and stockholders expect earnings to grow overtime as a result of retained earnings and inflation. Further, dividends arenormally expected to grow more or less in line with earnings. Thus,today a “stable dividend policy” generally means increasing the dividendat a reasonably steady rate.

Dividend stability has two components: (1) How dependable is thegrowth rate, and (2) can we count on at least receiving the current divi-dend in the future? The most stable policy, from an investor’s standpoint,is that of a firm whose dividend growth rate is predictable — such a com-pany’s total return (dividend yield plus capital gains yield) would be rela-tively stable over the long run, and its stock would be a good hedgeagainst inflation. The second most stable policy is where stockholders canbe reasonably sure that the current dividend will not be reduced — it maynot grow at a steady rate, but management will probably be able to avoidcutting the dividend. The least stable situation is where earnings and cashflows are so volatile that investors cannot count on the company to main-tain the current dividend over a typical business cycle.

3. Most observers believe that dividend stability is desirable. Assuming thisposition is correct, investors prefer stocks that pay more predictable div-idends to stocks that pay the same average amount of dividends but in amore erratic manner. This means that the cost of equity will be mini-mized, and the stock price maximized, if a firm stabilizes its dividends asmuch as possible.

D I V I D E N D S TA B I L I T Y

SELF-TEST QUESTIONS

What does the term “stable dividend policy” mean?

What are the two components of dividend stability?


E S TA B L I S H I N G T H E D I V I D E N D P O L I C Y I N P R AC T I C E

In the preceding sections we saw that investors may or may not prefer divi-dends to capital gains, but that they do prefer predictable to unpredictabledividends. Given this situation, how should a firm determine the specific per-centage of earnings that it will pay out as dividends? While policies undoubt-edly vary from firm to firm, we describe in this section the steps that a typicalfirm takes when it establishes its target payout ratio.

SETT ING THE TARGET PAYOUT RATIO: THE RESIDUAL DIVIDEND MODEL7

When deciding how much cash to distribute to stockholders, two pointsshould be kept in mind: (1) The overriding objective is to maximize share-holder value, and (2) the firm’s cash flows really belong to its shareholders, somanagement should refrain from retaining income unless they can reinvest itto produce returns higher than shareholders could themselves earn by invest-ing the cash in investments of equal risk. On the other hand, recall fromChapter 10 that internal equity (retained earnings) is cheaper than externalequity (new common stock). This encourages firms to retain earnings becausethey add to the equity base, increase debt capacity, and thus reduce the likeli-hood that the firm will have to issue common stock at a later date to fund fu-ture investment projects.

When establishing a dividend policy, one size does not fit all. Some firmsproduce a lot of cash but have limited investment opportunities — this is truefor firms in profitable but mature industries where few opportunities forgrowth exist. Such firms typically distribute a large percentage of their cash toshareholders, thereby attracting investment clienteles that prefer high divi-dends. Other firms generate little or no excess cash but have many good in-vestment opportunities — this is often true of new firms in rapidly growing in-dustries. Such firms generally distribute little or no cash but enjoy risingearnings and stock prices, thereby attracting investors who prefer capitalgains.

As Table 14-1 suggests, dividend payouts and dividend yields for large cor-porations vary considerably. Generally, firms in stable, cash-producing indus-tries such as utilities, financial services, and tobacco pay relatively high divi-dends, whereas companies in rapidly growing industries such as computer andcable TV tend to pay lower dividends.

7 The term “payout ratio” can be interpreted in two ways: (1) the conventional way, where the pay-out ratio means the percentage of net income to common paid out as cash dividends, or (2) the per-centage of net income distributed to stockholders as dividends and through share repurchases. In this section, we assume that no repurchases occur. Increasingly, though, firms are using the resid-ual model to determine “distributions to shareholders” and then making a separate decision as tothe form of that distribution. Further, an increasing percentage of the distribution is in the form ofshare repurchases.

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For a given firm, the optimal payout ratio is a function of four factors: (1) in-vestor’s preferences for dividends versus capital gains, (2) the firm’s investmentopportunities, (3) its target capital structure, and (4) the availability and cost ofexternal capital. The last three elements are combined in what we call theresidual dividend model. Under this model a firm follows these four stepswhen establishing its target payout ratio: (1) It determines the optimal capitalbudget; (2) it determines the amount of equity needed to finance that budget,given its target capital structure; (3) it uses retained earnings to meet equity re-quirements to the extent possible; and (4) it pays dividends only if more earn-ings are available than are needed to support the optimal capital budget. Theword residual implies “leftover,” and the residual policy implies that dividendsare paid out of “leftover” earnings.

If a firm rigidly follows the residual dividend policy, then dividends paid inany given year can be expressed as follows:

Dividends � Net income � Retained earnings required to help finance new investments

� Net income � [(Target equity ratio)(Total capital budget)].

For example, suppose the target equity ratio is 60 percent and the firm plans tospend $50 million on capital projects. In that case, it would need $50(0.6) �$30 million of common equity. Then, if its net income were $100 million,its dividends would be $100 � $30 � $70 million. So, if the company had


Residual Dividend ModelA model in which the dividendpaid is set equal to net incomeminus the amount of retainedearnings necessary to finance thefirm’s optimal capital budget.

T A B L E 1 4 - 1

DIVIDEND DIVIDENDCOMPANY INDUSTRY PAYOUT YIELD

I. COMPANIES THAT PAY HIGH DIVIDENDS

Pennzoil-Quaker States Automotive consumer products 99% 6.3%AGL Resources Natural gas distribution 90 5.4Flowers Ind. Food processing 88 3.3CSX Corp. Rail transportation 86 4.8Goodyear Tire Tire and rubber 72 5.2Alliance Cap. Mgmt. Financial services 68 7.7II. COMPANIES THAT PAY LITTLE OR NO DIVIDENDS

McDonald’s Fast-food restaurants 15% 0.7%Compaq Computer Computers 11 0.5Intel Corp. Semiconductor 5 0.2Delta Air Lines Airline 3 0.2Starbucks Coffee retailer 0 0Sun Microsystems Computers 0 0

SOURCE: Value Line Investment Survey, CD-ROM, November 2000.

Dividend Payouts


$100 million of earnings and a capital budget of $50 million, it would use $30million of the retained earnings plus $50 � $30 � $20 million of new debt tofinance the capital budget, and this would keep its capital structure on target.Note that the amount of equity needed to finance new investments might ex-ceed the net income; in our example, this would happen if the capital budgetwere $200 million. In that case, no dividends would be paid, and the companywould have to issue new common stock in order to maintain its target capitalstructure.

Most firms have a target capital structure that calls for at least some debt, sonew financing is done partly with debt and partly with equity. As long as thefirm finances with the optimal mix of debt and equity, and provided it uses onlyinternally generated equity (retained earnings), then the marginal cost of eachnew dollar of capital will be minimized. Internally generated equity is availablefor financing a certain amount of new investment, but beyond that amount, thefirm must turn to more expensive new common stock. At the point where newstock must be sold, the cost of equity, and consequently the marginal cost ofcapital, rises.

To illustrate these points, consider the case of Texas and Western (T&W)Transport Company. T&W’s overall composite cost of capital is 10 percent.However, this cost assumes that all new equity comes from retained earnings.If the company must issue new stock, its cost of capital will be higher. T&Whas $60 million in net income and a target capital structure of 60 percent eq-uity and 40 percent debt. Provided that it does not pay any cash dividends,T&W could make net investments (investments in addition to asset replace-ments from depreciation) of $100 million, consisting of $60 million from re-tained earnings plus $40 million of new debt supported by the retained earn-ings, at a 10 percent marginal cost of capital. If the capital budget exceeded$100 million, the required equity component would exceed net income, whichis of course the maximum amount of retained earnings. In this case, T&Wwould have to issue new common stock, thereby pushing its cost of capitalabove 10 percent.8

At the beginning of its planning period, T&W’s financial staff considers allproposed projects for the upcoming period. Independent projects are acceptedif their estimated returns exceed the risk-adjusted cost of capital. In choosingamong mutually exclusive projects, T&W chooses the project with the highestpositive NPV. The capital budget represents the amount of capital that is re-quired to finance all accepted projects. If T&W follows a strict residual divi-dend policy, we can see from Table 14-2 that the estimated capital budget willhave a profound effect on its dividend payout ratio.

If T&W forecasts poor investment opportunities, its estimated capital bud-get will be only $40 million. To maintain the target capital structure, 40 per-cent of this capital ($16 million) must be raised as debt, and 60 percent ($24million) must be equity. If it followed a strict residual policy, T&W would

8 If T&W does not retain all of its earnings, its cost of capital will rise above 10 percent before itscapital budget reaches $100 million. For example, if T&W chose to retain $36 million, its cost ofcapital would increase once the capital budget exceeded $36/0.6 � $60 million. To see this point,note that a capital budget of $60 million would require $36 million of equity — if the capital bud-get rose above $60 million, the company’s required equity capital would exceed its retained earn-ings, thereby requiring it to issue new common stock.

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retain $24 million to help finance new investments, then pay out the remaining$36 million as dividends. Under this scenario, the company’s dividend payoutratio would be $36 million/$60 million � 0.6 � 60%.

By contrast, if the company’s investment opportunities were average, its op-timal capital budget would rise to $70 million. Here it would require $42 mil-lion of retained earnings, so dividends would be $60 � $42 � $18 million, fora payout of $18/$60 � 30%. Finally, if investment opportunities are good, thecapital budget would be $150 million, which would require 0.6($150) � $90million of equity. T&W would retain all of its net income ($60 million), thuspay no dividends. Moreover, since the required equity exceeds the retainedearnings, the company would have to issue new common stock in order tomaintain the target capital structure.

Since investment opportunities and earnings will surely vary from year toyear, strict adherence to the residual dividend policy would result in unstabledividends. One year the firm might pay zero dividends because it needed themoney to finance good investment opportunities, but the next year it mightpay a large dividend because investment opportunities were poor and it there-fore did not need to retain much. Similarly, fluctuating earnings could alsolead to variable dividends, even if investment opportunities were stable. There-fore, following the residual dividend policy would almost certainly lead to fluc-tuating, unstable dividends. Thus, following the residual dividend policy wouldbe optimal only if investors were not bothered by fluctuating dividends. How-ever, since investors prefer stable, dependable dividends, ks would be higher,and the stock price lower, if the firm followed the residual model in a strictsense rather than attempting to stabilize its dividends over time. Therefore,firms should

1. Estimate the firm’s earnings and investment opportunities, on average,over the next five or so years.

2. Use this forecasted information to find the residual model payout ratioand dollars of dividends during the planning period.

3. Then set a target payout ratio on the basis of the projected data.


T A B L E 1 4 - 2

INVESTMENT OPPORTUNITIES

POOR AVERAGE GOOD

Capital budget $40 $70 $150

Net income $60 $60 $ 60Required equity (0.6 � Capital budget) 24 42 90Dividends paid (NI � Required equity) $36 $18 �$ 30a

Dividend payout ratio (Dividend/NI) 60% 30% 0%

a With a $150 million capital budget, T&W would retain all of its earnings and also issue $30 million of new stock.

T&W’s Dividend Payout Ratio with $60 Million of Net Income When Faced with Different Investment Opportunities (Dollars in Millions)


Thus, firms should use the residual policy to help set their long-run target payout ra-tios, but not as a guide to the payout in any one year.

Companies do use the residual dividend model as discussed above to helpunderstand the determinants of an optimal dividend policy, but they typicallyuse a computerized financial forecasting model when setting the target payoutratio. Most larger corporations forecast their financial statements over the nextfive to ten years. Information on projected capital expenditures and workingcapital requirements is entered into the model, along with sales forecasts, profitmargins, depreciation, and the other elements required to forecast cash flows.The target capital structure is also specified, and the model shows the amountof debt and equity that will be required to meet the capital budgeting require-ments while maintaining the target capital structure.

Then, dividend payments are introduced. Naturally, the higher the payoutratio, the greater the required external equity. Most companies use themodel to find a dividend pattern over the forecast period (generally fiveyears) that will provide sufficient equity to support the capital budget with-out having to sell new common stock or move the capital structure ratiosoutside the optimal range. The end result might include a statement, in amemo from the financial vice-president to the chairman of the board, suchas the following:

We forecasted the total market demand for our products, what our share of the mar-ket is likely to be, and our required investments in capital assets and working capital.Using this information, we developed projected balance sheets and income state-ments for the period 2002–2006.

Our 2001 dividends totaled $50 million, or $2 per share. On the basis of projectedearnings, cash flows, and capital requirements, we can increase the dividend by 8 per-cent per year. This is consistent with a payout ratio of 42 percent, on average, overthe forecast period. Any faster dividend growth rate (or higher payout) would requireus to sell common stock, cut the capital budget, or raise the debt ratio. Any slowergrowth rate would lead to increases in the common equity ratio. Therefore, I rec-ommend that the Board increase the dividend for 2002 by 8 percent, to $2.16, andthat it plan for similar increases in the future.

Events over the next five years will undoubtedly lead to differences between ourforecasts and actual results. If and when such events occur, we will want to reexam-ine our position. However, I am confident that we can meet any random cash short-falls by increasing our borrowings — we have unused debt capacity that gives us flex-ibility in this regard.

We ran the corporate model under several recession scenarios. If the economyreally crashes, our earnings will not cover the dividend. However, in all “reasonable”scenarios our cash flows do cover the dividend. I know the Board does not want topush the dividend up to a level where we would have to cut it under bad economicconditions. Our model runs indicate, though, that the $2.16 dividend can be main-tained under any reasonable set of forecasts. Only if we increased the dividend toover $3 would we be seriously exposed to the danger of having to cut the dividend.

I might also note that Value Line and most other analysts’ reports are forecastingthat our dividends will grow in the 6 percent to 8 percent range. Thus, if we go to$2.16, we will be at the high end of the range, which should give our stock a boost.With takeover rumors so widespread, getting the stock up a bit would make us allbreathe a little easier.

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Finally, we considered distributing cash to shareholders through a stock repur-chase program. Here we would reduce the dividend payout ratio and use the fundsso generated to buy our stock on the open market. Such a program has several ad-vantages, but it would also have drawbacks. I do not recommend that we institute astock repurchase program at this time. However, if our free cash flows exceed ourforecasts, I would recommend that we use these surpluses to buy back stock. Also, Iplan to continue looking into a regular repurchase program, and I may recommendsuch a program in the future.

This company has very stable operations, so it can plan its dividends with afairly high degree of confidence. Other companies, especially those in cyclicalindustries, have difficulty maintaining in bad times a dividend that is really toolow in good times. Such companies set a very low “regular” dividend and thensupplement it with an “extra” dividend when times are good. General Motors,Ford, and other auto companies have followed the low-regular-dividend-plus-extras policy in the past. Each company announced a low regular divi-dend that it was sure could be maintained “through hell or high water,” andstockholders could count on receiving that dividend under all conditions.Then, when times were good and profits and cash flows were high, the compa-nies paid a clearly designated extra dividend. Investors recognized that theextras might not be maintained in the future, so they did not interpret them asa signal that the companies’ earnings were going up permanently, nor did theytake the elimination of the extra as a negative signal. In recent years, however,the auto companies and many other companies have replaced the “extras” intheir low-regular-dividend-plus-extras policy with stock repurchases.

EARNINGS, CASH FLOWS, AND DIVIDENDS

We normally think of earnings as being the primary determinant of dividends,but in reality cash flows are more important. This situation is revealed in Fig-ure 14-2, which gives data for Chevron Corporation from 1979 through 2000.Chevron’s dividends increased steadily from 1979 to 1981; during that periodboth earnings and cash flows were rising, as was the price of oil. After 1981, oilprices declined sharply, pulling earnings down. Cash flows, though, remainedwell above the dividend requirement.

Chevron acquired Gulf Oil in 1984, and it issued more than $10 billion ofdebt to finance the acquisition. Interest on the debt hurt earnings immediatelyafter the merger, as did certain write-offs connected with the merger. Further,Chevron’s management wanted to pay off the new debt as fast as possible. Allof this influenced the company’s decision to hold the dividend constant from1982 through 1987. Earnings improved dramatically in 1988, and the divi-dend has increased more or less steadily since then. Note that the dividendwas increased in 1991 in spite of the weak earnings and cash flow resultingfrom the Persian Gulf War. More recently, in October 2000, Chevron an-nounced that it plans to merge with Texaco. If the deal is ultimately com-pleted, it will be interesting to see how this merger affects Chevron’s futuredividend policy.

Now look at Columns 4 and 6, which show payout ratios based on earningsand on cash flows. The earnings payout is quite volatile — dividends ranged


Low-Regular-Dividend-plus-ExtrasThe policy of announcing a low,regular dividend that can bemaintained no matter what, andthen when times are good payinga designated “extra” dividend.


from 26 percent to 120 percent of earnings. The cash flow payout, on the otherhand, is much more stable — it ranged from 19 percent to 44 percent. Further,the correlation between dividends and cash flows was 0.79 versus 0.53 betweendividends and earnings. Thus, dividends clearly depend more on cash flows,which reflect the company’s ability to pay dividends, than on current earnings,which are heavily influenced by accounting practices and which do not neces-sarily reflect the ability to pay dividends.

PAYMENT PROCEDURES

Dividends are normally paid quarterly, and, if conditions permit, the dividendis increased once each year. For example, Katz Corporation paid $0.50 perquarter in 2001, or at an annual rate of $2.00. In common financial parlance,we say that in 2001 Katz’s regular quarterly dividend was $0.50, and its annualdividend was $2.00. In late 2001, Katz’s board of directors met, reviewed pro-

F I G U R E 1 4 - 2 Chevron: Earnings, Cash Flows, and Dividends, 1979–2000

19981980 1982 1984 1986 1988 1990

2

4

6

8

10

12

14

16

DPS

EPS

CFPS

2000

Year

Dollars

1992 1994 1996

18

20

22

24

jections for 2001, and decided to keep the 2002 dividend at $2.00. The direc-tors announced the $2 rate, so stockholders could count on receiving it unlessthe company experienced unanticipated operating problems.

The actual payment procedure is as follows:

1. Declaration date. On the declaration date — say, on November 9 —the directors meet and declare the regular dividend, issuing a statementsimilar to the following: “On November 9, 2001, the directors of KatzCorporation met and declared the regular quarterly dividend of 50 centsper share, payable to holders of record on December 7, payment to bemade on January 2, 2002.” For accounting purposes, the declared divi-dend becomes an actual liability on the declaration date. If a balancesheet were constructed, the amount ($0.50) � (Number of shares out-standing) would appear as a current liability, and retained earnings wouldbe reduced by a like amount.

2. Holder-of-record date. At the close of business on the holder-of-record date, December 7, the company closes its stock transfer booksand makes up a list of shareholders as of that date. If Katz Corporation isnotified of the sales before 5 P.M. on December 7, then the new owner re-ceives the dividend. However, if notification is received on or after De-cember 8, the previous owner gets the dividend check.

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F I G U R E 1 4 - 2 Chevron: Earnings, Cash Flows, and Dividends, 1979–2000 (continued)

YEAR DIVIDENDS PER SHARE EARNINGS PER SHARE EARNINGS PAYOUT CASH FLOW PER SHARE CASH FLOW PAYOUT(1) (2) (3) (4) (5) (6)

1979 $1.45 $5.22 28% $ 7.29 20%1980 1.80 7.02 26 9.26 191981 2.20 6.96 32 9.61 231982 2.40 4.03 60 7.35 331983 2.40 5.15 47 8.93 271984 2.40 4.94 49 9.00 271985 2.40 4.19 57 12.76 191986 2.40 2.63 91 9.86 241987 2.40 2.13 113 9.47 251988 2.55 4.86 52 11.97 211989 2.80 4.16 67 11.33 251990 2.95 6.02 49 13.75 211991 3.25 3.69 88 11.28 291992 3.30 4.70 70 12.88 261993 3.50 5.60 63 13.12 271994 3.70 5.20 71 12.66 291995 3.85 6.02 64 13.36 291996 4.16 8.12 51 14.90 281997 4.56 9.66 47 16.70 271998 4.88 4.08 120 11.20 441999 4.96 6.28 79 15.04 332000 5.20 15.90 33 24.10 22

NOTE: For consistency, data have not been adjusted for a two-for-one split in 1994.

SOURCE: Value Line Investment Survey, various issues.

Declaration DateThe date on which a firm’sdirectors issue a statementdeclaring a dividend.


Holder-of-Record DateIf the company lists thestockholder as an owner on thisdate, then the stockholder receivesthe dividend.


3. Ex-dividend date. Suppose Jean Buyer buys 100 shares of stock from JohnSeller on December 4. Will the company be notified of the transfer in timeto list Buyer as the new owner and thus pay the dividend to her? To avoidconflict, the securities industry has set up a convention under which theright to the dividend remains with the stock until two business days priorto the holder-of-record date; on the second day before that date, the rightto the dividend no longer goes with the shares. The date when the right tothe dividend leaves the stock is called the ex-dividend date. In this case,the ex-dividend date is two days prior to December 7, or December 5:

Dividend goes with stock: December 4Ex-dividend date: December 5

December 6Holder-of-record date: December 7

Therefore, if Buyer is to receive the dividend, she must buy the stock onor before December 4. If she buys it on December 5 or later, Seller willreceive the dividend because he will be the official holder of record.

Katz’s dividend amounts to $0.50, so the ex-dividend date is important.Barring fluctuations in the stock market, one would normally expect theprice of a stock to drop by approximately the amount of the dividend onthe ex-dividend date. Thus, if Katz closed at $301⁄2 on December 4, itwould probably open at about $30 on December 5.9

4. Payment date. The company actually mails the checks to the holders ofrecord on January 2, the payment date.

9 Tax effects cause the price decline on average to be less than the full amount of the dividend. Sup-pose you were an investor in the 40 percent federal-plus-state tax bracket. If you bought Katz’sstock on December 4, you would receive the dividend, but you would almost immediately pay 40percent of it out in taxes. Thus, you would want to wait until December 5, to buy the stock if youthought you could get it for $0.50 less per share. Your reaction, and that of others, would influencestock prices around dividend payment dates. Here is what would happen:

1. Other things held constant, a stock’s price should rise during the quarter, with the dailyprice increase (for Katz) equal to $0.50/90 � $0.005556. Therefore, if the price started at$30 just after its last ex-dividend date, it would rise to $30.50 on December 4.

Payment DateThe date on which a firm actuallymails dividend checks.

SELF-TEST QUESTIONS

Explain the logic of the residual dividend model, the steps a firm would taketo implement it, and why it is more likely to be used to establish a long-runpayout target than to set the actual year-by-year payout ratio.

How do firms use planning models to help set dividend policy?

Which are more critical to the dividend decision, earnings or cash flow?Explain.

Explain the procedures used to actually pay the dividend.

Why is the ex-dividend date important to investors?

(footnote continues)

Ex-Dividend DateThe date on which the right to thecurrent dividend no longeraccompanies a stock; it is usuallytwo business days prior to theholder-of-record date.

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D I V I D E N D R E I N V E S T M E N T P L A N S

During the 1970s, most large companies instituted dividend reinvestmentplans (DRIPs), whereby stockholders can automatically reinvest their dividendsin the stock of the paying corporation.10 Today most larger companies offerDRIPs, and although participation rates vary considerably, about 25 percent ofthe average firm’s shareholders are enrolled. There are two types of DRIPs:(1) plans that involve only “old stock” that is already outstanding and (2) plansthat involve newly issued stock. In either case, the stockholder must pay taxes onthe amount of the dividends, even though stock rather than cash is received.

Under both types of DRIPs, stockholders choose between continuing to re-ceive dividend checks or having the company use the dividends to buy morestock in the corporation. Under the “old stock” type of plan, if a stockholderelects reinvestment, a bank, acting as trustee, takes the total funds available forreinvestment, purchases the corporation’s stock on the open market, and allo-cates the shares purchased to the participating stockholders’ accounts on a prorata basis. The transactions costs of buying shares (brokerage costs) are low be-cause of volume purchases, so these plans benefit small stockholders who donot need cash dividends for current consumption.

The “new stock” type of DRIP invests the dividends in newly issued stock,hence these plans raise new capital for the firm. AT&T, Xerox, Union Carbide,and many other companies have had new stock plans in effect in recent years,using them to raise substantial amounts of new equity capital. No fees arecharged to stockholders, and many companies offer stock at a discount of 3 per-cent to 5 percent below the actual market price. The companies offer discountsas a trade-off against flotation costs that would be incurred if new stock hadbeen issued through investment bankers rather than through the dividend rein-vestment plans.

One interesting aspect of DRIPs is that they are forcing corporations to re-examine their basic dividend policies. A high participation rate in a DRIP sug-gests that stockholders might be better off if the firm simply reduced cash div-idends, which would save stockholders some personal income taxes. Quite a fewfirms are surveying their stockholders to learn more about their preferencesand to find out how they would react to a change in dividend policy. A more ra-tional approach to basic dividend policy decisions may emerge from thisresearch.

D I V I D E N D R E I N V E S T M E N T P L A N S

(Footnote 9 continued)2. In the absence of taxes, the stock’s price would fall to $30 on December 5 and then start up

as the next dividend accrual period began. Thus, over time, if everything else were held con-stant, the stock’s price would follow a sawtooth pattern if it were plotted on a graph.

3. Because of taxes, the stock’s price would neither rise by the full amount of the dividend norfall by the full dividend amount when it goes ex-dividend.

4. The amount of the rise and subsequent fall would depend on the average investor’s marginaltax rate.

See Edwin J. Elton and Martin J. Gruber, “Marginal Stockholder Tax Rates and the Clientele Ef-fect,” Review of Economics and Statistics, February 1970, 68–74, for an interesting discussion of allthis.10 See Richard H. Pettway and R. Phil Malone, “Automatic Dividend Reinvestment Plans,” Finan-cial Management, Winter 1973, 11–18, for an old but still excellent discussion of the subject.

Dividend Reinvestment Plan(DRIP)A plan that enables a stockholderto automatically reinvest dividendsreceived back into the stock of thepaying firm.


Note that companies start or stop using new stock DRIPs depending ontheir need for equity capital. Thus, both Union Carbide and AT&T recentlystopped offering a new stock DRIP with a 5 percent discount because theirneeds for equity capital declined. However, about the same time Xerox begansuch a plan.

Some companies have expanded their DRIPs by moving to “open enroll-ment,” whereby anyone can purchase the firm’s stock directly and thus bypassbrokers’ commissions. Exxon Mobil not only allows investors to buy their ini-tial shares at no fee but also lets them pick up additional shares through au-tomatic bank account withdrawals. Several plans, including Exxon Mobil’s,offer dividend reinvestment for individual retirement accounts, and some,such as U.S. West, allow participants to invest weekly or monthly rather thanon the quarterly dividend schedule. In all of these plans, and many others,stockholders can invest more than the dividends they are foregoing — theysimply send a check to the company and buy shares without a brokerage com-mission. According to First Chicago Trust, which handles the paperwork for13 million shareholder DRIP accounts, at least half of all DRIPs will offeropen enrollment, extra purchases, and other expanded services within the nextfew years.

SELF-TEST QUESTIONS

What are dividend reinvestment plans?

What are their advantages and disadvantages from both the stockholders’and the firm’s perspectives?

S U M M A R Y O F FAC TO R S I N F L U E N C I N G D I V I D E N D P O L I C Y

In earlier sections, we described both the major theories of investor preferenceand some issues concerning the effects of dividend policy on the value of a firm.We also discussed the residual dividend model for setting a firm’s long-run tar-get payout ratio. In this section, we discuss several other factors that affect thedividend decision. These factors may be grouped into four broad categories:(1) constraints on dividend payments, (2) investment opportunities, (3) avail-ability and cost of alternative sources of capital, and (4) effects of dividendpolicy on ks. Each of these categories has several subparts, which we discuss inthe following paragraphs.

CONSTRAINTS

1. Bond indentures. Debt contracts often limit dividend payments to earn-ings generated after the loan was granted. Also, debt contracts often stip-ulate that no dividends can be paid unless the current ratio, times-interest-earned ratio, and other safety ratios exceed stated minimums.

663

2. Preferred stock restrictions. Typically, common dividends cannot bepaid if the company has omitted its preferred dividend. The preferred ar-rearages must be satisfied before common dividends can be resumed.

3. Impairment of capital rule. Dividend payments cannot exceed the bal-ance sheet item “retained earnings.” This legal restriction, known as theimpairment of capital rule, is designed to protect creditors. Without therule, a company that is in trouble might distribute most of its assets tostockholders and leave its debtholders out in the cold. (Liquidating divi-dends can be paid out of capital, but they must be indicated as such, andthey must not reduce capital below the limits stated in debt contracts.)

4. Availability of cash. Cash dividends can be paid only with cash. Thus, ashortage of cash in the bank can restrict dividend payments. However, theability to borrow can offset this factor.

5. Penalty tax on improperly accumulated earnings. To prevent wealthyindividuals from using corporations to avoid personal taxes, the Tax Codeprovides for a special surtax on improperly accumulated income. Thus, ifthe IRS can demonstrate that a firm’s dividend payout ratio is being de-liberately held down to help its stockholders avoid personal taxes, thefirm is subject to heavy penalties. This factor is generally relevant only toprivately owned firms.

INVESTMENT OPPORTUNIT IES

1. Number of profitable investment opportunities. If a firm typically hasa large number of profitable investment opportunities, this will tend toproduce a low target payout ratio, and vice versa if the firm’s profitableinvestment opportunities are few in number.

2. Possibility of accelerating or delaying projects. The ability to acceler-ate or postpone projects will permit a firm to adhere more closely to astable dividend policy.

ALTERNAT IVE SOURCES OF CAPITAL

1. Cost of selling new stock. If a firm needs to finance a given level of in-vestment, it can obtain equity by retaining earnings or by issuing newcommon stock. If flotation costs (including any negative signaling effectsof a stock offering) are high, ke will be well above ks, making it better toset a low payout ratio and to finance through retention rather thanthrough sale of new common stock. On the other hand, a high dividendpayout ratio is more feasible for a firm whose flotation costs are low.Flotation costs differ among firms — for example, the flotation percentageis generally higher for small firms, so they tend to set low payout ratios.

2. Ability to substitute debt for equity. A firm can finance a given level ofinvestment with either debt or equity. As noted above, low stock flotationcosts permit a more flexible dividend policy because equity can be raisedeither by retaining earnings or by selling new stock. A similar situationholds for debt policy: If the firm can adjust its debt ratio without raising

S U M M A R Y O F FAC TO R S I N F L U E N C I N G D I V I D E N D P O L I C Y


costs sharply, it can pay the expected dividend, even if earnings fluctuate,by increasing its debt ratio.

3. Control. If management is concerned about maintaining control, it maybe reluctant to sell new stock, hence the company may retain more earn-ings than it otherwise would. However, if stockholders want higher divi-dends and a proxy fight looms, then the dividend will be increased.

EFFECTS OF DIVIDEND POLICY ON ks

The effects of dividend policy on ks may be considered in terms of four factors:(1) stockholders’ desire for current versus future income, (2) perceived riskinessof dividends versus capital gains, (3) the tax advantage of capital gains over div-idends, and (4) the information content of dividends (signaling). Since we dis-cussed each of these factors in detail earlier, we need only note here that theimportance of each factor in terms of its effect on ks varies from firm to firmdepending on the makeup of its current and possible future stockholders.

It should be apparent from our discussion that dividend policy decisions aretruly exercises in informed judgment, not decisions that can be quantified pre-cisely. Even so, to make rational dividend decisions, financial managers musttake account of all the points discussed in the preceding sections.

SELF-TEST QUESTIONS

Identify the four broad sets of factors that affect dividend policy.

What constraints affect dividend policy?

How do investment opportunities affect dividend policy?

How does the availability and cost of outside capital affect dividend policy?

OV E R V I E W O F T H E D I V I D E N D P O L I C Y D E C I S I O N

In many ways, our discussion of dividend policy parallels our discussion of cap-ital structure: We presented the relevant theories and issues, and we listed someadditional factors that influence dividend policy, but we did not come up withany hard-and-fast guidelines that managers can follow. It should be apparentfrom our discussion that dividend policy decisions are exercises in informedjudgment, not decisions that can be based on a precise mathematical model.

In practice, dividend policy is not an independent decision — the dividenddecision is made jointly with capital structure and capital budgeting decisions.The underlying reason for this joint decision process is asymmetric informa-tion, which influences managerial actions in two ways:

1. In general, managers do not want to issue new common stock. First, newcommon stock involves issuance costs — commissions, fees, and so on —and those costs can be avoided by using retained earnings to finance the

665

firm’s equity needs. Also, as we discussed in Chapter 13, asymmetric in-formation causes investors to view new common stock issues as negativesignals and thus lowers expectations regarding the firm’s future prospects.The end result is that the announcement of a new stock issue usuallyleads to a decrease in the stock price. Considering the total costs in-volved, including both issuance and asymmetric information costs, man-agers strongly prefer to use retained earnings as their primary source ofnew equity.

2. Dividend changes provide signals about managers’ beliefs as to theirfirms’ future prospects. Thus, dividend reductions, or worse yet, omis-sions, generally have a significant negative effect on a firm’s stock price.Since managers recognize this, they try to set dollar dividends lowenough so that there is only a remote chance that the dividend will haveto be reduced in the future. Of course, unexpectedly large dividend in-creases can be used to provide positive signals.

The effects of asymmetric information suggest that, to the extent possible,managers should avoid both new common stock sales and dividend cuts, be-cause both actions tend to lower stock prices. Thus, in setting dividend pol-icy, managers should begin by considering the firm’s future investment oppor-tunities relative to its projected internal sources of funds. The firm’s targetcapital structure also plays a part, but because the optimal capital structure isa range, firms can vary their actual capital structures somewhat from year toyear. Since it is best to avoid issuing new common stock, the target long-termpayout ratio should be designed to permit the firm to meet all of its equitycapital requirements with retained earnings. In effect, managers should usethe residual dividend model to set dividends, but in a long-term framework.Finally, the current dollar dividend should be set so that there is an extremelylow probability that the dividend, once set, will ever have to be lowered oromitted.

Of course, the dividend decision is made during the planning process, sothere is uncertainty about future investment opportunities and operating cashflows. Thus, the actual payout ratio in any year will probably be above or belowthe firm’s long-range target. However, the dollar dividend should be main-tained, or increased as planned, unless the firm’s financial condition deterioratesto the point where the planned policy simply cannot be maintained. A steady orincreasing stream of dividends over the long run signals that the firm’s financialcondition is under control. Further, investor uncertainty is decreased by stabledividends, so a steady dividend stream reduces the negative effect of a newstock issue, should one become absolutely necessary.

In general, firms with superior investment opportunities should set lowerpayouts, hence retain more earnings, than firms with poor investment opportu-nities. The degree of uncertainty also influences the decision. If there is a greatdeal of uncertainty in the forecasts of free cash flows, which are defined here asthe firm’s operating cash flows minus mandatory equity investments, then it isbest to be conservative and to set a lower current dollar dividend. Also, firmswith postponable investment opportunities can afford to set a higher dollar div-idend, because in times of stress investments can be postponed for a year ortwo, thus increasing the cash available for dividends. Finally, firms whose costof capital is largely unaffected by changes in the debt ratio can also afford to seta higher payout ratio, because they can, in times of stress, more easily issue

OV E R V I E W O F T H E D I V I D E N D P O L I C Y D E C I S I O N


additional debt to maintain the capital budgeting program without having tocut dividends or issue stock.

Firms have only one opportunity to set the dividend payment from scratch.Therefore, today’s dividend decisions are constrained by policies that were setin the past, hence setting a policy for the next five years necessarily begins witha review of the current situation.

Although we have outlined a rational process for managers to use when set-ting their firms’ dividend policies, dividend policy still remains one of the mostjudgmental decisions that firms must make. For this reason, dividend policy isalways set by the board of directors — the financial staff analyzes the situationand makes a recommendation, but the board makes the final decision.

SELF-TEST QUESTION

Describe the dividend policy decision process. Be sure to discuss all the fac-tors that influence the decision.

S TO C K D I V I D E N D S A N D S TO C K S P L I T S

Stock dividends and stock splits are related to the firm’s cash dividend policy.The rationale for stock dividends and splits can best be explained through anexample. We will use Porter Electronic Controls Inc., a $700 million electroniccomponents manufacturer, for this purpose. Since its inception, Porter’s mar-kets have been expanding, and the company has enjoyed growth in sales andearnings. Some of its earnings have been paid out in dividends, but some arealso retained each year, causing its earnings per share and stock price to grow.The company began its life with only a few thousand shares outstanding, and,after some years of growth, each of Porter’s shares had a very high EPS andDPS. When a “normal” P/E ratio was applied, the derived market price was sohigh that few people could afford to buy a “round lot” of 100 shares. This lim-ited the demand for the stock and thus kept the total market value of the firmbelow what it would have been if more shares, at a lower price, had been out-standing. To correct this situation, Porter “split its stock,” as described in thenext section.

STOCK SPLITS

Although there is little empirical evidence to support the contention, there isnevertheless a widespread belief in financial circles that an optimal price rangeexists for stocks. “Optimal” means that if the price is within this range, theprice/earnings ratio, hence the firm’s value, will be maximized. Many observers,including Porter’s management, believe that the best range for most stocks isfrom $20 to $80 per share. Accordingly, if the price of Porter’s stock rose to$80, management would probably declare a two-for-one stock split, thus dou-bling the number of shares outstanding, halving the earnings and dividends pershare, and thereby lowering the stock price. Each stockholder would have more

Stock SplitAn action taken by a firm toincrease the number of sharesoutstanding, such as doubling thenumber of shares outstanding bygiving each stockholder two newshares for each one formerly held.

667S TO C K D I V I D E N D S A N D S TO C K S P L I T S

LOOKING ONLINE FOR INFORMATION ON STOCK SPLITS AND STOCK REPURCHASES

Up-to-date information about changes in stock splits andstock repurchases is now just a few clicks away. While this

information is reported on several web sites, a good place toget started is the Online Investor at http://www.

investhelp.com. Online Investor’s home page includes recentstock repurchase and stock split announcements at “Buybacks”and “Splits Center.”


shares, but each share would be worth less. If the post-split price were $40,Porter’s stockholders would be exactly as well off as they were before the split.However, if the stock price were to stabilize above $40, stockholders would bebetter off. Stock splits can be of any size — for example, the stock could be splittwo-for-one, three-for-one, one-and-a-half-for-one, or in any other way.11

STOCK DIVIDENDS

Stock dividends are similar to stock splits in that they “divide the pie intosmaller slices” without affecting the fundamental position of the current stock-holders. On a 5 percent stock dividend, the holder of 100 shares would receivean additional 5 shares (without cost); on a 20 percent stock dividend, the sameholder would receive 20 new shares; and so on. Again, the total number ofshares is increased, so earnings, dividends, and price per share all decline.

If a firm wants to reduce the price of its stock, should it use a stock split ora stock dividend? Stock splits are generally used after a sharp price run-up toproduce a large price reduction. Stock dividends used on a regular annual basiswill keep the stock price more or less constrained. For example, if a firm’s earn-ings and dividends were growing at about 10 percent per year, its stock pricewould tend to go up at about that same rate, and it would soon be outside thedesired trading range. A 10 percent annual stock dividend would maintain thestock price within the optimal trading range. Note, though, that small stockdividends create bookkeeping problems and unnecessary expenses, so firmstoday use stock splits far more often than stock dividends.12

EFFECT ON STOCK PRICES

If a company splits its stock or declares a stock dividend, will this increase themarket value of its stock? Several empirical studies have sought to answer thisquestion. Here is a summary of their findings.13

11 Reverse splits, which reduce the shares outstanding, can even be used. For example, a companywhose stock sells for $5 might employ a one-for-five reverse split, exchanging one new share forfive old ones and raising the value of the shares to about $25, which is within the optimal pricerange. LTV Corporation did this after several years of losses had driven its stock price below theoptimal range.12 Accountants treat stock splits and stock dividends somewhat differently. For example, in a two-for-one stock split, the number of shares outstanding is doubled and the par value is halved, andthat is about all there is to it. With a stock dividend, a bookkeeping entry is made transferring “re-tained earnings” to “common stock.” For example, if a firm had 1,000,000 shares outstanding, if thestock price was $10, and if it wanted to pay a 10 percent stock dividend, then (1) each stockholderwould be given one new share of stock for each 10 shares held, and (2) the accounting entries wouldinvolve showing 100,000 more shares outstanding and transferring 100,000($10) � $1,000,000from “retained earnings” to “common stock.” The retained earnings transfer limits the size of stockdividends, but that is not important because companies can always split their stock in any way theychoose.13 See Eugene F. Fama, Lawrence Fisher, Michael C. Jensen, and Richard Roll, “The Adjustment ofStock Prices to New Information,” International Economic Review, February 1969, 1–21; Mark S.Grinblatt, Ronald M. Masulis, and Sheridan Titman, “The Valuation Effects of Stock Splits andStock Dividends,” Journal of Financial Economics, December 1984, 461–490; C. Austin Barker, “Eval-uation of Stock Dividends,” Harvard Business Review, July–August 1958, 99–114; and Thomas E.Copeland, “Liquidity Changes Following Stock Splits,” Journal of Finance, March 1979, 115–141.

Stock DividendA dividend paid in the form ofadditional shares of stock ratherthan in cash.

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1. On average, the price of a company’s stock rises shortly after it announcesa stock split or dividend.

2. However, these price increases are more the result of the fact that in-vestors take stock splits/dividends as signals of higher future earnings anddividends than of a desire for stock dividends/splits per se. Since onlycompanies whose managements think things look good tend to split theirstocks, the announcement of a stock split is taken as a signal that earningsand cash dividends are likely to rise. Thus, the price increases associatedwith stock splits/dividends are probably the result of signals of favorableprospects for earnings and dividends, not a desire for stock splits/dividendsper se.

3. If a company announces a stock split or dividend, its price will tend torise. However, if during the next few months it does not announce an in-crease in earnings and dividends, then its stock price will drop back to theearlier level.

4. As we noted earlier, brokerage commissions are generally higher in per-centage terms on lower-priced stocks. This means that it is more expen-sive to trade low-priced than high-priced stocks, and this, in turn, meansthat stock splits may reduce the liquidity of a company’s shares. This par-ticular piece of evidence suggests that stock splits/dividends might actu-ally be harmful, although a lower price does mean that more investorscan afford to trade in round lots (100 shares), which carry lower commis-sions than do odd lots (less than 100 shares).

What do we conclude from all this? From a pure economic standpoint, stockdividends and splits are just additional pieces of paper. However, they providemanagement with a relatively low-cost way of signaling that the firm’s prospectslook good. Further, we should note that since few large, publicly owned stockssell at prices above several hundred dollars, we simply do not know what theeffect would be if Microsoft, Xerox, Hewlett-Packard, and other highly success-ful firms had never split their stocks, and consequently sold at prices in the thou-sands or even tens of thousands of dollars. All in all, it probably makes sense toemploy stock dividends/splits when a firm’s prospects are favorable, especially ifthe price of its stock has gone beyond the normal trading range.14

S TO C K D I V I D E N D S A N D S TO C K S P L I T S

14 It is interesting to note that Berkshire Hathaway, which is controlled by billionaire Warren Buf-fett, one of the most successful financiers of the twentieth century, has never had a stock split, andits stock sold on the NYSE for $65,000 per share in December 2000. But, in response to invest-ment trusts that were being formed to sell fractional units of the stock, and thus, in effect, split it,Buffett himself created a new class of Berkshire Hathaway stock (Class B) worth about 1⁄30 of aClass A (regular) share.

SELF-TEST QUESTIONS

What are stock dividends and stock splits?

How do stock dividends and splits affect stock prices?

In what situations should managers consider the use of stock dividends?

In what situations should they consider the use of stock splits?


S TO C K R E P U R C H A S E S

Several years ago, a Fortune article entitled “Beating the Market by Buying BackStock” discussed the fact that during a one-year period, more than 600 majorcorporations repurchased significant amounts of their own stock. It also gave il-lustrations of some specific companies’ repurchase programs and the effects ofthese programs on stock prices. The article’s conclusion was that “buybacks havemade a mint for shareholders who stay with the companies carrying them out.”

In addition, we noted earlier that several years ago FPL cut its dividends butsimultaneously instituted a program to repurchase shares of its stock. Thus, itsubstituted share repurchases for cash dividends as a way to distribute funds tostockholders. FPL is not alone — in recent years Philip Morris, GE, Disney,Citigroup, Merck, and more than 800 other companies took similar actions,and the dollars used to repurchase shares approximately matched the amountpaid out as dividends.

Why are stock repurchase programs becoming so popular? The short an-swer is that they enhance shareholder value: A more complete answer is givenin the remainder of this section, where we explain what a stock repurchase is,how it is carried out, and how the financial manager should analyze a possiblerepurchase program.

There are three principal types of repurchases: (1) situations where the firmhas cash available for distribution to its stockholders, and it distributes this cashby repurchasing shares rather than by paying cash dividends; (2) situationswhere the firm concludes that its capital structure is too heavily weighted withequity, and then it sells debt and uses the proceeds to buy back its stock; and (3)situations where a firm has issued options to employees and then uses openmarket repurchases to obtain stock for use when the options are exercised.

Stock that has been repurchased by a firm is called treasury stock. If some ofthe outstanding stock is repurchased, fewer shares will remain outstanding. As-suming that the repurchase does not adversely affect the firm’s future earnings,the earnings per share on the remaining shares will increase, resulting in ahigher market price per share. As a result, capital gains will have been substi-tuted for dividends.

THE EFFECTS OF STOCK REPURCHASES

Many companies have been repurchasing their stock in recent years. Until the1980s, most repurchases amounted to a few million dollars, but in 1985, PhillipsPetroleum announced plans for the largest repurchase on record — 81 million ofits shares with a market value of $4.1 billion. Other large repurchases have beenmade by Texaco, IBM, CBS, Coca-Cola, Teledyne, Atlantic Richfield, Goodyear,and Xerox. Indeed, since 1985, more shares have been repurchased than issued.

The effects of a repurchase can be illustrated with data on American Devel-opment Corporation (ADC). The company expects to earn $4.4 million in2002, and 50 percent of this amount, or $2.2 million, has been allocated for dis-tribution to common shareholders. There are 1.1 million shares outstanding,and the market price is $20 a share. ADC believes that it can either use the $2.2

Stock RepurchaseA transaction in which a firm buysback shares of its own stock,thereby decreasing sharesoutstanding, increasing EPS, and,often, increasing the stock price.

671S TO C K R E P U R C H A S E S

15 Stock repurchases are generally made in one of three ways: (1) A publicly owned firm can sim-ply buy its own stock through a broker on the open market. (2) It can make a tender offer, underwhich it permits stockholders to send in (that is, “tender”) their shares to the firm in exchange fora specified price per share. In this case, it generally indicates that it will buy up to a specified num-ber of shares within a particular time period (usually about two weeks); if more shares are tenderedthan the company wishes to purchase, purchases are made on a pro rata basis. (3) The firm can pur-chase a block of shares from one large holder on a negotiated basis. If a negotiated purchase is em-ployed, care must be taken to ensure that this one stockholder does not receive preferential treat-ment over other stockholders or that any preference given can be justified by “sound businessreasons.” Texaco’s management was sued by stockholders who were unhappy over the company’srepurchase of about $600 million of stock from the Bass Brothers’ interests at a substantial pre-mium over the market price. The suit charged that Texaco’s management, afraid the Bass Brotherswould attempt a takeover, used the buyback to get them off its back. Such payments have beendubbed “greenmail.”

STOCK REPURCHASES: AN EASY WAY TO BOOST STOCK PRICES?

Looking for a way to boost your company’s stock price? Whynot buy back some of your company’s shares? That reflects

the thinking of an increasing number of financial managers.The buyback rage is in some ways surprising. Given the re-

cent performance of the stock market, it has become quite ex-pensive to buy back shares. Nevertheless, the market’s responseto a buyback announcement is usually positive. For example, inmid-1996 Reebok announced that it would buy back one-thirdof its outstanding shares, and on the announcement day, thestock price rose 10 percent. Reebok’s experience is not unique.A recent study found (1) that the average company’s stock rose3.5 percent the day a buyback was announced and (2) thatcompanies that repurchase shares outperform the market over afour-year period following the announcement.a

Why are buybacks so popular with investors? The generalview is that financial managers are signaling to the investmentcommunity a belief that the stock is undervalued, hence thatthe company thinks its own stock is an attractive investment.In this respect, stock repurchases have the opposite effect ofstock issuances, which are thought to signal that the firm’sstock is overvalued. Buybacks also help assure investors thatthe company is not wasting its shareholders’ money by invest-

ing in sub-par investments. Michael O’Neill, the CFO ofBankAmerica, puts it this way: “We look very hard internally,but if we don’t have a profitable use for capital, we think weshould return it to shareholders.”

Despite all the recent hoopla surrounding buybacks, manyanalysts stress that in some instances repurchases have adownside: If a firm’s stock is actually overvalued, buying backshares at the inflated price will harm the remaining stockhold-ers. In this regard, buybacks should not be viewed as a gimmickto boost stock prices in the short run, but should be used onlyif they are part of a well-thought-out strategy for investmentand for distributing cash to stockholders. Indeed, buybacks donot always succeed — Disney, for example, announced a buy-back in April 1996, and its stock price fell more than 10 per-cent in the next six months.

a David Ikenberry, Josef Lakonishok, and Theo Vermaelen, “Market Under-Reactionto Open Market Share Repurchases,” Journal of Financial Economics, 1995, Vol. 39,181–208.

SOURCE: Adapted from “Buybacks Make News, But Do They Make Sense?” Busi-nessWeek, August 12, 1996, 76.

million to repurchase 100,000 of its shares through a tender offer at $22 a shareor else pay a cash dividend of $2 a share.15

The effect of the repurchase on the EPS and market price per share of theremaining stock can be analyzed in the following way:

1.

2. P/E ratio �$20$4

� 5�.

Current EPS �Total earnings

Number of shares�

$4.4 million1.1 million

� $4 per share.


3. EPS after repurchasing 100,000 shares

4. Expected market price after repurchase � (P/E)(EPS) � (5)($4.40)

� $22 per share.

It should be noted from this example that investors would receive before-taxbenefits of $2 per share in any case, either in the form of a $2 cash dividend ora $2 increase in the stock price. This result would occur because we assumed,first, that shares could be repurchased at exactly $22 a share and, second, thatthe P/E ratio would remain constant. If shares could be bought for less than$22, the operation would be even better for remaining stockholders, but the re-verse would hold if ADC had to pay more than $22 a share. Furthermore, theP/E ratio might change as a result of the repurchase operation, rising if

�$4.4 million

1 million� $4.40 per share.

BUYBACKS HAVE LOWERED DIVIDEND YIELDS

Dividend payouts and yields have fallen sharply over the pasttwo decades. In 1980, the average large company paid out

55 percent of its earnings as dividends, and its dividend yieldexceeded 5 percent. Today, the average payout is less than 40percent, and the yield has dipped below 1.5 percent.

A number of theories have been offered to explain these re-sults. First, declining dividend yields imply that stock priceshave increased faster than dividends paid. Some analysts pointto the low yields as evidence that the stock market is overval-ued. Second, lower interest rates led to a decline in requiredstock returns. This increased stock prices, which, in turn, re-sulted in lower dividend yields. Third, over the past twodecades the composition of the stock market has changed dra-matically. In 1980, the market was dominated by oil, industrial,utility, and retail companies that paid high dividends. Todaythe market includes many high-tech companies that pay littleor no dividends.

In addition, dividend yields have fallen because more andmore companies now recognize the tax and other advantages ofstock repurchases over dividends as a way of distributing cashto shareholders. Indeed, stock repurchases have tripled in re-cent years, and in each year since 1997 stock repurchases haveexceeded cash dividends paid.

The popularity of stock repurchases led Federal ReserveBoard economists Nellie Liang and Steve Sharpe to redefine astock’s “total yield.” First, they developed a “net repurchasesyield,” calculated as the dollars per share spent on repurchasesminus the cost of shares used to cover the exercise of stock op-tions, divided by the stock price. Then, the stock’s “total yield”is found as the sum of the traditional dividend yield plus thenet repurchases yield.

Liang and Sharpe’s estimated yields for the largest 144 com-panies in the S&P 500 during 1994–1998 are reported in theaccompanying table. These data confirm the declining impor-tance of dividends and the increasing importance of stock re-purchases. They also indicate that total yields have been trend-ing downward. Even after including stock repurchases, totalyields are still only half of what the dividend yield alone was in1980. Thus, no matter how you slice it, payouts to sharehold-ers have declined. This is, of course, consistent with lower in-terest rates and a declining cost of equity capital.

SOURCE: Gene Epstein, “Soaring Buybacks Make Dividend Yield a Misleading Mea-sure of a Stock’s Value,” Barron’s Online, November 1, 1999.

YIELDS 1994 1995 1996 1997 1998

Dividend yield 2.76% 2.41% 2.06% 1.73% 1.41%Repurchase yield 1.19% 1.34% 1.56% 1.98% 1.49%Total yield 3.95% 3.75% 3.62% 3.71% 2.90%Percent of repurchases 30% 36% 43% 53% 51%

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investors viewed it favorably and falling if they viewed it unfavorably. Somefactors that might affect P/E ratios are considered next.

ADVANTAGES OF REPURCHASES

The advantages of repurchases are as follows:

1. Repurchase announcements are viewed as positive signals by investors be-cause the repurchase is often motivated by management’s belief that thefirm’s shares are undervalued.

2. The stockholders have a choice when the firm distributes cash by repur-chasing stock — they can sell or not sell. With a cash dividend, on theother hand, stockholders must accept a dividend payment and pay the tax.Thus, those stockholders who need cash can sell back some of theirshares, while those who do not want additional cash can simply retaintheir stock. From a tax standpoint, a repurchase permits both types ofstockholders to get what they want.

3. A third advantage is that a repurchase can remove a large block of stockthat is “overhanging” the market and keep the price per share down.

4. Dividends are “sticky” in the short run because managements are reluc-tant to raise the dividend if the increase cannot be maintained in the fu-ture — managements dislike cutting cash dividends because of the nega-tive signal a cut gives. Hence, if the excess cash flow is thought to be onlytemporary, management may prefer to make the distribution in the formof a share repurchase rather than to declare an increased cash dividendthat cannot be maintained.

5. Companies can use the residual model to set a target cash distribution level,then divide the distribution into a dividend component and a repurchase com-ponent. The dividend payout ratio will be relatively low, but the dividenditself will be relatively secure, and it will grow as a result of the decliningnumber of shares outstanding. The company has more flexibility in ad-justing the total distribution than it would if the entire distribution werein the form of cash dividends, because repurchases can be varied fromyear to year without giving off adverse signals. This procedure, which iswhat FPL employed, has much to recommend it, and it is a primary rea-son for the dramatic increase in the volume of share repurchases.

6. Repurchases can be used to produce large-scale changes in capital struc-tures. For example, several years ago Consolidated Edison decided to re-purchase $400 million of its common stock in order to increase its debtratio. The repurchase was necessary because even if the company fi-nanced its capital budget only with debt, it would still have taken years toget the debt ratio up to the target level. Con Ed used the repurchase toproduce a rapid change in its capital structure.

7. Companies that use stock options as an important component of em-ployee compensation can repurchase shares and then use those shareswhen employees exercise their options. This avoids the issuance of newshares and a resulting dilution of earnings. Microsoft and other high-techcompanies have used this procedure in recent years.

S TO C K R E P U R C H A S E S


DISADVANTAGES OF REPURCHASES

Disadvantages of repurchases include the following:

1. Stockholders may not be indifferent between dividends and capital gains,and the price of the stock might benefit more from cash dividends thanfrom repurchases. Cash dividends are generally dependable, but repur-chases are not. Further, if many firms announced regular, dependable re-purchase programs, the improper accumulation tax might become athreat.

2. The selling stockholders may not be fully aware of all the implications ofa repurchase, or they may not have all the pertinent information aboutthe corporation’s present and future activities. However, firms generallyannounce repurchase programs before embarking on them to avoid po-tential stockholder suits.

3. The corporation may pay too high a price for the repurchased stock, tothe disadvantage of remaining stockholders. If its shares are not activelytraded, and if the firm seeks to acquire a relatively large amount of itsstock, then the price may be bid above its equilibrium level and then fallafter the firm ceases its repurchase operations.

CONCLUSIONS ON STOCK REPURCHASES

When all the pros and cons on stock repurchases have been totaled, where dowe stand? Our conclusions may be summarized as follows:

1. Because of the lower capital gains tax rate and the deferred tax on capitalgains, repurchases have a significant tax advantage over dividends as a wayto distribute income to stockholders. This advantage is reinforced by thefact that repurchases provide cash to stockholders who want cash butallow those who do not need current cash to delay its receipt. On theother hand, dividends are more dependable and are thus better suited forthose who need a steady source of income.

2. Because of signaling effects, companies should not vary their dividends —that would lower investors’ confidence in the company and adversely af-fect its cost of equity and its stock price. However, cash flows vary overtime, as do investment opportunities, so the “proper” dividend in theresidual model sense varies. To get around this problem, a company can setits dividend at a level low enough to keep dividend payments from con-straining operations and then use repurchases on a more or less regularbasis to distribute excess cash. Such a procedure would provide regular,dependable dividends plus additional cash flow to those stockholders whowant it.

3. Repurchases are also useful when a firm wants to make a large shift in itscapital structure within a short period of time, wants to distribute cashfrom a one-time event such as the sale of a division, or wants to obtainshares for use in an employee stock option plan.

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In an earlier edition of this book, we argued that companies ought to be doingmore repurchasing and paying out less cash as dividends than they were.Increases in the size and frequency of repurchases in recent years suggest thatcompanies have reached this same conclusion.

T Y I N G I T A L L TO G E T H E R

SELF-TEST QUESTIONS

Explain how repurchases can (1) help stockholders hold down taxes and (2)help firms change their capital structures.

What is treasury stock?

What are three procedures a firm can use to repurchase its stock?

What are some advantages and disadvantages of stock repurchases?

How can stock repurchases help a company operate in accordance with theresidual dividend model?

Once a company becomes profitable, it must decide what to do with the cashit generates. It may choose to retain cash and use it to purchase additional as-sets or to reduce outstanding debt. Alternatively, it may choose to return cashto shareholders. Keep in mind that every dollar that management chooses toretain is a dollar that shareholders could have received and invested elsewhere.Therefore, managers should retain earnings if and only if they can invest themoney within the firm and earn more than stockholders could earn outsidethe firm. Consequently, high-growth companies with many good projects willtend to retain a high percentage of earnings, whereas mature companies withlots of cash but limited investment opportunities will have generous cash dis-tributions.

This basic tendency has a major influence on firms’ long-run distributionpolicies. However, as we saw in this chapter, in any given year several impor-tant situations could complicate the long-run policy. Companies with excesscash have to decide whether to pay dividends or repurchase stock. In addition,due to the importance of signaling and the clientele effect, companies generallyfind it desirable to maintain a stable, consistent dividend policy over time. Thekey concepts covered in this chapter are listed below.

� Dividend policy involves three issues: (1) What fraction of earningsshould be distributed? (2) Should the distribution be in the form of cashdividends or stock repurchases? (3) Should the firm maintain a steady, sta-ble dividend growth rate?

� The optimal dividend policy strikes a balance between current dividendsand future growth so as to maximize the firm’s stock price.


� Miller and Modigliani developed the dividend irrelevance theory, whichholds that a firm’s dividend policy has no effect on either the value of itsstock or its cost of capital.

� The bird-in-the-hand theory holds that the firm’s value will be maxi-mized by a high dividend payout ratio, because investors regard cash div-idends as being less risky than potential capital gains.

� The tax preference theory states that because long-term capital gains aresubject to less onerous taxes than dividends, investors prefer to have com-panies retain earnings rather than pay them out as dividends.

� Empirical tests of the three theories have been inconclusive. There-fore, academicians cannot tell corporate managers how a given change individend policy will affect stock prices and capital costs.

� Dividend policy should take account of the information content of div-idends (signaling) and the clientele effect. The information content, orsignaling, effect relates to the fact that investors regard an unexpected div-idend change as a signal of management’s forecast of future earnings. Theclientele effect suggests that a firm will attract investors who like the firm’sdividend payout policy. Both factors should be considered by firms thatare considering a change in dividend policy.

� In practice, most firms try to follow a policy of paying a steadily increas-ing dividend. This policy provides investors with stable, dependable in-come, and departures from it give investors signals about management’sexpectations for future earnings.

� Most firms use the residual dividend model to set the long-run targetpayout ratio at a level that will permit the firm to satisfy its equity re-quirements with retained earnings.

� A dividend reinvestment plan (DRIP) allows stockholders to have thecompany automatically use dividends to purchase additional shares ofstock. DRIPs are popular because they allow stockholders to acquire ad-ditional shares without incurring brokerage fees.

� Legal constraints, investment opportunities, availability and cost offunds from other sources, and taxes are also considered when firms es-tablish dividend policies.

� A stock split increases the number of shares outstanding. Normally, splitsreduce the price per share in proportion to the increase in shares becausesplits merely “divide the pie into smaller slices.” However, firms generallysplit their stocks only if (1) the price is quite high and (2) managementthinks the future is bright. Therefore, stock splits are often taken as posi-tive signals and thus boost stock prices.

� A stock dividend is a dividend paid in additional shares of stock ratherthan in cash. Both stock dividends and splits are used to keep stock priceswithin an “optimal” trading range.

� Under a stock repurchase plan, a firm buys back some of its out-standing stock, thereby decreasing the number of shares, which shouldincrease both EPS and the stock price. Repurchases are useful for mak-ing major changes in capital structure, as well as for distributing excesscash.

677

Q U E S T I O N S

14-1 How would each of the following changes tend to affect aggregate (that is, the averagefor all corporations) payout ratios, other things held constant? Explain your answers.a. An increase in the personal income tax rate.b. A liberalization of depreciation for federal income tax purposes — that is, faster tax

write-offs.c. A rise in interest rates.d. An increase in corporate profits.e. A decline in investment opportunities.f. Permission for corporations to deduct dividends for tax purposes as they now do in-

terest charges.g. A change in the Tax Code so that both realized and unrealized capital gains in any

year were taxed at the same rate as dividends.14-2 Discuss the pros and cons of having the directors formally announce what a firm’s divi-

dend policy will be in the future.14-3 Most firms would like to have their stock selling at a high P/E ratio, and they would also

like to have extensive public ownership (many different shareholders). Explain howstock dividends or stock splits may help achieve these goals.

14-4 What is the difference between a stock dividend and a stock split? As a stockholder,would you prefer to see your company declare a 100 percent stock dividend or a two-for-one split? Assume that either action is feasible.

14-5 “The cost of retained earnings is less than the cost of new outside equity capital. Con-sequently, it is totally irrational for a firm to sell a new issue of stock and to pay divi-dends during the same year.” Discuss this statement.

14-6 Would it ever be rational for a firm to borrow money in order to pay dividends? Explain.14-7 “Executive salaries have been shown to be more closely correlated to the size of the firm

than to its profitability. If a firm’s board of directors is controlled by management in-stead of by outside directors, this might result in the firm’s retaining more earnings thancan be justified from the stockholders’ point of view.” Discuss the statement, being sure(a) to discuss the interrelationships among cost of capital, investment opportunities, andnew investment and (b) to explain the implied relationship between dividend policy andstock prices.

14-8 Modigliani and Miller (MM) on the one hand and Gordon and Lintner (GL) on theother have expressed strong views regarding the effect of dividend policy on a firm’s costof capital and value.a. In essence, what are the MM and GL views regarding the effect of dividend policy

on the cost of capital and stock prices?b. How does the tax preference theory differ from the views of MM and GL?c. According to the text, which of the theories, if any, has received statistical confirma-

tion from empirical tests?d. How could MM use the information content, or signaling, hypothesis to counter their

opponents’ arguments? If you were debating MM, how would you counter them?e. How could MM use the clientele effect concept to counter their opponents’ argu-

ments? If you were debating MM, how would you counter them?14-9 More NYSE companies had stock dividends and stock splits during 1983 and 1984 than

ever before. What events in these years could have made stock splits and stock dividendsso popular? Explain the rationale that a financial vice-president might give his or herboard of directors to support a stock split/dividend recommendation.

14-10 One position expressed in the financial literature is that firms set their dividends as aresidual after using income to support new investment.a. Explain what a residual dividend policy implies, illustrating your answer with a table

showing how different investment opportunities could lead to different dividend pay-out ratios.

b. Think back to Chapter 13, where we considered the relationship between capitalstructure and the cost of capital. If the WACC-versus-debt-ratio plot were shapedlike a sharp V, would this have a different implication for the importance of setting

Q U E S T I O N S


dividends according to the residual policy than if the plot were shaped like a shallowbowl (or a flattened U)?

14-11 Indicate whether the following statements are true or false. If the statement is false, ex-plain why.a. If a firm repurchases its stock in the open market, the shareholders who tender the

stock are subject to capital gains taxes.b. If you own 100 shares in a company’s stock and the company’s stock splits two for

one, you will own 200 shares in the company following the split.c. Some dividend reinvestment plans increase the amount of equity capital available to

the firm.d. The Tax Code encourages companies to pay a large percentage of their net income

in the form of dividends.e. If your company has established a clientele of investors who prefer large dividends,

the company is unlikely to adopt a residual dividend policy.f. If a firm follows a residual dividend policy, holding all else constant, its dividend pay-

out will tend to rise whenever the firm’s investment opportunities improve.

S E L F - T E S T P R O B L E M S ( S O L U T I O N S A P P E A R I N A P P E N D I X B )

Define each of the following terms:a. Optimal dividend policyb. Dividend irrelevance theory; bird-in-the-hand theory; tax preference theoryc. Information content, or signaling, hypothesis; clientele effectd. Residual dividend modele. Extra dividendf. Declaration date; holder-of-record date; ex-dividend date; payment dateg. Dividend reinvestment plan (DRIP)h. Stock split; stock dividendi. Stock repurchase

Components Manufacturing Corporation (CMC) has an all-common-equity capitalstructure. It has 200,000 shares of $2 par value common stock outstanding. WhenCMC’s founder, who was also its research director and most successful inventor, retiredunexpectedly to the South Pacific in late 2001, CMC was left suddenly and permanentlywith materially lower growth expectations and relatively few attractive new investmentopportunities. Unfortunately, there was no way to replace the founder’s contributions tothe firm. Previously, CMC found it necessary to plow back most of its earnings to financegrowth, which averaged 12 percent per year. Future growth at a 5 percent rate is consid-ered realistic, but that level would call for an increase in the dividend payout. Further, itnow appears that new investment projects with at least the 14 percent rate of return re-quired by CMC’s stockholders (ks � 14%) would amount to only $800,000 for 2002 incomparison to a projected $2,000,000 of net income. If the existing 20 percent dividendpayout were continued, retained earnings would be $1.6 million in 2002, but, as noted,investments that yield the 14 percent cost of capital would amount to only $800,000.

The one encouraging point is that the high earnings from existing assets are ex-pected to continue, and net income of $2 million is still expected for 2002. Given thedramatically changed circumstances, CMC’s management is reviewing the firm’s divi-dend policy.a. Assuming that the acceptable 2002 investment projects would be financed entirely by

earnings retained during the year, calculate DPS in 2002, assuming that CMC usesthe residual dividend model.

b. What payout ratio does your answer to part a imply for 2002?c. If a 60 percent payout ratio is maintained for the foreseeable future, what is your es-

timate of the present market price of the common stock? How does this comparewith the market price that should have prevailed under the assumptions existing justbefore the news about the founder’s retirement? If the two values of P0 are different,comment on why.

d. What would happen to the price of the stock if the old 20 percent payout were con-tinued? Assume that if this payout is maintained, the average rate of return on the re-tained earnings will fall to 7.5 percent and the new growth rate will be

ST-2Alternative dividend policies

ST-1Key terms

679

g � (1.0 � Payout ratio)(ROE)� (1.0 � 0.2)(7.5%)� (0.8)(7.5%) � 6.0%.

S TA R T E R P R O B L E M S

Axel Telecommunications has a target capital structure that consists of 70 percent debtand 30 percent equity. The company anticipates that its capital budget for the upcom-ing year will be $3,000,000. If Axel reports net income of $2,000,000 and it follows aresidual dividend payout policy, what will be its dividend payout ratio?Gamma Medical’s stock trades at $90 a share. The company is contemplating a 3-for-2stock split. Assuming that the stock split will have no effect on the market value of itsequity, what will be the company’s stock price following the stock split?Beta Industries has net income of $2,000,000 and it has 1,000,000 shares of commonstock outstanding. The company’s stock currently trades at $32 a share. Beta is con-sidering a plan in which it will use available cash to repurchase 20 percent of itsshares in the open market. The repurchase is expected to have no effect on either netincome or the company’s P/E ratio. What will be its stock price following the stockrepurchase?

E X A M - T Y P E P R O B L E M S

The problems included in this section are set up in such a way that they could be used as multiple-choice exam problems.Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for itspatented solar heating system. To meet this demand, management plans to expandproduction capacity by 40 percent with a $10 million investment in plant and ma-chinery. The firm wants to maintain a 40 percent debt-to-total-assets ratio in its cap-ital structure; it also wants to maintain its past dividend policy of distributing 45 per-cent of last year’s net income. In 2001, net income was $5 million. How muchexternal equity must Northern Pacific seek at the beginning of 2002 to expand ca-pacity as desired? Assume the firm uses only debt and common equity in its capitalstructure.Petersen Company has a capital budget of $1.2 million. The company wants to maintaina target capital structure that is 60 percent debt and 40 percent equity. The companyforecasts that its net income this year will be $600,000. If the company follows a resid-ual dividend policy, what will be its payout ratio?The Wei Corporation expects next year’s net income to be $15 million. The firm’s debtratio is currently 40 percent. Wei has $12 million of profitable investment opportunities,and it wishes to maintain its existing debt ratio. According to the residual dividendmodel, how large should Wei’s dividend payout ratio be next year? Assume the firm usesonly debt and common equity in its capital structure.After a 5-for-1 stock split, the Strasburg Company paid a dividend of $0.75 per newshare, which represents a 9 percent increase over last year’s pre-split dividend. What waslast year’s dividend per share?The Welch Company is considering three independent projects, each of which requiresa $5 million investment. The estimated internal rate of return (IRR) and cost of capitalfor these projects is presented below:

Project H (High risk): Cost of capital � 16%; IRR � 20%.Project M (Medium risk): Cost of capital � 12%; IRR � 10%.Project L (Low risk): Cost of capital � 8%; IRR � 9%.

14-8Residual dividend model

14-7Stock split



14-4External equity financing

14-3Stock repurchases

14-2Stock split


E X A M - T Y P E P R O B L E M S


Note that the projects’ cost of capital varies because the projects have different levels ofrisk. The company’s optimal capital structure calls for 50 percent debt and 50 percentcommon equity. Welch expects to have net income of $7,287,500. If Welch bases its div-idends on the residual model, what will its payout ratio be?

P R O B L E M S

Bowles Sporting Inc. is prepared to report the following income statement (shown inthousands of dollars) for the year 2002.

Sales $15,200Operating costs including depreciation 11,900EBIT $ 3,300Interest 300EBT $ 3,000Taxes (40%) 1,200Net income $ 1,800

Prior to reporting this income statement, the company wants to determine its annualdividend. The company has 500,000 shares of stock outstanding and its stock trades at$48 per share.a. The company had a 40 percent dividend payout ratio in 2001. If Bowles wants to

maintain this payout ratio in 2002, what will be its per-share dividend in 2002?b. If the company maintains this 40 percent payout ratio, what will be the current div-

idend yield on the company’s stock?c. The company reported net income of $1.5 million in 2001. Assume that the number

of shares outstanding has remained constant. What was the company’s per-share div-idend in 2001?

d. As an alternative to maintaining the same dividend payout ratio, Bowles is consider-ing maintaining the same per-share dividend in 2002 that it paid in 2001. If itchooses this policy, what will be the company’s dividend payout ratio in 2002?

e. Assume that the company is interested in dramatically expanding its operations andthat this expansion will require significant amounts of capital. The company wouldlike to avoid transactions costs involved in issuing new equity. Given this scenario,would it make more sense for the company to maintain a constant dividend payoutratio or to maintain the same per-share dividend?

In 2001 the Keenan Company paid dividends totaling $3,600,000 on net income of$10.8 million. 2001 was a normal year, and for the past 10 years, earnings have grown ata constant rate of 10 percent. However, in 2002, earnings are expected to jump to $14.4million, and the firm expects to have profitable investment opportunities of $8.4 million.It is predicted that Keenan will not be able to maintain the 2002 level of earningsgrowth — the high 2002 earnings level is attributable to an exceptionally profitable newproduct line introduced that year — and the company will return to its previous 10 per-cent growth rate. Keenan’s target capital structure is 40 percent debt and 60 percentequity.a. Calculate Keenan’s total dividends for 2002 if it follows each of the following policies:

(1) Its 2002 dividend payment is set to force dividends to grow at the long-rungrowth rate in earnings.

(2) It continues the 2001 dividend payout ratio.(3) It uses a pure residual dividend policy (40 percent of the $8.4 million investment

is financed with debt and 60 percent with common equity).(4) It employs a regular-dividend-plus-extras policy, with the regular dividend being

based on the long-run growth rate and the extra dividend being set according tothe residual policy.

b. Which of the preceding policies would you recommend? Restrict your choices to theones listed, but justify your answer.

14-10Alternative dividend policies

14-9Dividends

681

c. Assume that investors expect Keenan to pay total dividends of $9,000,000 in 2002and to have the dividend grow at 10 percent after 2002. The stock’s total marketvalue is $180 million. What is the company’s cost of equity?

d. What is Keenan’s long-run average return on equity? [Hint: g � (Retention rate) �(ROE) � (1.0 � Payout rate)(ROE).]

e. Does a 2002 dividend of $9,000,000 seem reasonable in view of your answers to partsc and d? If not, should the dividend be higher or lower?

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It haspaid a $3.00 dividend per share (DPS) for the past several years, and its shareholders ex-pect the dividend to remain constant for the next several years. The company’s targetcapital structure is 60 percent equity and 40 percent debt; it has 1,000,000 shares ofcommon equity outstanding; and its net income is $8 million. The company forecaststhat it would require $10 million to fund all of its profitable (i.e., positive NPV) projectsfor the upcoming year.a. If Buena Terra follows the residual dividend model, how much retained earnings will

it need to fund its capital budget?b. If Buena Terra follows the residual dividend model, what will be the company’s divi-

dend per share and payout ratio for the upcoming year?c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained

earnings will be available for the firm’s capital budget?d. Can the company maintain its current capital structure, maintain the $3.00 DPS,

and maintain a $10 million capital budget without having to raise new commonstock?

e. Suppose that Buena Terra’s management is firmly opposed to cutting the dividend,that is, it wishes to maintain the $3.00 dividend for the next year. Also, assume thatthe company was committed to funding all profitable projects and was willing toissue more debt (along with the available retained earnings) to help finance the com-pany’s capital budget. Assume that the resulting change in capital structure has a min-imal impact on the company’s composite cost of capital, so that the capital budget re-mains at $10 million. What portion of this year’s capital budget would have to befinanced with debt?

f. Suppose once again that Buena Terra’s management wants to maintain the $3.00DPS. In addition, the company wants to maintain its target capital structure (60 per-cent equity, 40 percent debt) and maintain its $10 million capital budget. What is theminimum dollar amount of new common stock that the company would have to issuein order to meet each of its objectives?

g. Now consider the case where Buena Terra’s management wants to maintain the $3.00DPS and its target capital structure, but it wants to avoid issuing new common stock.The company is willing to cut its capital budget in order to meet its other objectives.Assuming that the company’s projects are divisible, what will be the company’s capi-tal budget for the next year?

h. What actions can a firm that follows the residual dividend policy take when its fore-casted retained earnings are less than the retained earnings required to fund its cap-ital budget?

S P R E A D S H E E T P R O B L E M

Rework Problem 14-11 parts a through g, using a spreadsheet model.14-12Residual dividend model


S P R E A D S H E E T P R O B L E M


The information related to this cyberproblem is likely to change over time, due to the releaseof new information and the ever-changing nature of the World Wide Web. Accordingly, wewill periodically update the problem on the textbook’s web site. To avoid problems, please checkfor updates before proceeding with the cyberproblems.Dividend reinvestment plans (DRIPs) enable stockholders to automatically reinvestdividends received back into the stock of the paying firm. In addition, many DRIPsallow their shareholders the option to buy more shares directly from the company byjust writing a check. The major advantage is that investors are able to avoid broker-age commissions. Although some plans require small service fees, these service feesusually pale in comparison to brokerage fees; however, the specific details of DRIPswill vary from plan to plan.

To learn about dividend reinvestment plans, you need to get back to basics. Let’sfind out what fools think about them, specifically the Motley Fool. For this cyber-problem, you will be going back to school with “Motley Fool’s School,” found athttp://www.fool.com/school.htm.

From the “Fool’s School” front page, scroll down to “Drip Investing” on theleft side of your computer screen. This link will take you to the “Investingthrough DRIPs” section of the Fool’s School. Make sure you also click on “start-ing a DRP” after reading the material on the first screen to answer the followingquestions:

a. According to the Fool, what are some of the advantages to DRIPs or DRPs, as theFool refers to them?

b. What variation of the traditional dividend reinvestment plan does the Foolmention?

14-13Dividend reinvestment plans

683I N T E G R AT E D C A S E

c. What effects can DRIPs have on participants’ investing and consumption habits?d. Describe the three kinds of DRIPs outlined by the Fool.e. Describe Direct Investment Plans (DIPs). What are the pros and cons of this pro-

gram?f. What pros and cons does the Fool mention for DRIPs/Optional Cash Purchase

Plans (OCPs)?

SOUTHEASTERN STEEL COMPANY

14–14 Dividend policy Southeastern Steel Company(SSC) was formed 5 years ago to exploit a new continuous-casting process. SSC’s founders, Donald Brown and MargoValencia, had been employed in the research department ofa major integrated-steel company, but when that companydecided against using the new process (which Brown and Va-lencia had developed), they decided to strike out on theirown. One advantage of the new process was that it requiredrelatively little capital in comparison with the typical steelcompany, so Brown and Valencia have been able to avoid is-suing new stock, and thus they own all of the shares. How-ever, SSC has now reached the stage in which outside equitycapital is necessary if the firm is to achieve its growth targetsyet still maintain its target capital structure of 60 percent eq-uity and 40 percent debt. Therefore, Brown and Valenciahave decided to take the company public. Until now, Brownand Valencia have paid themselves reasonable salaries butroutinely reinvested all after-tax earnings in the firm, so div-idend policy has not been an issue. However, before talkingwith potential outside investors, they must decide on a divi-dend policy.

Assume that you were recently hired by Arthur Adamson& Company (AA), a national consulting firm, which hasbeen asked to help SSC prepare for its public offering.Martha Millon, the senior AA consultant in your group, hasasked you to make a presentation to Brown and Valencia inwhich you review the theory of dividend policy and discussthe following questions.a. (1) What is meant by the term “dividend policy”?

(2) The terms “irrelevance,” “bird-in-the-hand,” and“tax preference” have been used to describe threemajor theories regarding the way dividend policy af-fects a firm’s value. Explain what these terms mean,and briefly describe each theory.

(3) What do the three theories indicate regarding the ac-tions management should take with respect to divi-dend policy?

(4) Explain the relationships between dividend policy,stock price, and the cost of equity under each divi-dend policy theory by constructing two graphs suchas those shown in Figure 14-1. Dividend payoutshould be placed on the X axis.

(5) What results have empirical studies of the dividendtheories produced? How does all this affect what wecan tell managers about dividend policy?

b. Discuss (1) the information content, or signaling, hy-pothesis, (2) the clientele effect, and (3) their effects ondividend policy.

c. (1) Assume that SSC has an $800,000 capital budgetplanned for the coming year. You have determinedthat its present capital structure (60 percent equityand 40 percent debt) is optimal, and its net income isforecasted at $600,000. Use the residual dividendmodel approach to determine SSC’s total dollar divi-dend and payout ratio. In the process, explain whatthe residual dividend model is. Then, explain whatwould happen if net income were forecasted at$400,000, or at $800,000.

(2) In general terms, how would a change in investmentopportunities affect the payout ratio under the resid-ual payment policy?

(3) What are the advantages and disadvantages of theresidual policy? (Hint: Don’t neglect signaling andclientele effects.)

d. What is a dividend reinvestment plan (DRIP), and howdoes it work?

e. Describe the series of steps that most firms take in settingdividend policy in practice.

f. What are stock repurchases? Discuss the advantages anddisadvantages of a firm’s repurchasing its own shares.

g. What are stock dividends and stock splits? What are theadvantages and disadvantages of stock dividends andstock splits?

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